THE WALL STREET JOURNALEmbrace the DeficitBy DAVID MALPASSDecember 21, 2006; Page A16For decades, the trade deficit has been a political and journalistic lightning rod, inspiring countless predictions of America's imminent economic collapse. The reality is different. Our imports grow with our economy and population while our exports grow with foreign economies, especially those of industrialized countries. Though widely criticized as an imbalance, the trade deficit and related capital inflow reflect U.S. growth, not weakness -- they link the younger, faster-growing U.S. with aging, slower-growing economies abroad.Since the 2001 recession, the U.S. economy has created 9.3 million new jobs, compared with 360,000 in Japan and 1.1 million in the euro zone excluding Spain. This despite our trade deficit and their trade surpluses. Like the U.S., Spain (3.6 million new jobs) and the U.K. (1.3 million new jobs) ran trade deficits and created jobs rapidly in this five-year period. Wages are rising solidly in these three. The economics is clear (for once) that a liberal trading environment allows more jobs with higher wages as people specialize.

The latest data on growth in jobs, retail sales and housing starts, and the record level of household savings, underscores the solid economy described by Fed Chairman Ben Bernanke last month. Supporting the "solid-growth" view are rising global stock markets, strong growth of corporate profits, the narrow credit spread between Treasurys and riskier bonds, and low interest rates relative to inflation and to growth -- nominal growth in the 12 months through September was 6%, yet the Fed funds rate, usually in line with nominal growth, only averaged 4.6%.The trade deficit and a low "personal savings rate" are key parts of the bond market's multi-year pessimism about the U.S. growth outlook. But just as the high level of U.S. savings is likely to add to future growth -- the savings rate is only low if you arbitrarily exclude gains -- the trade deficit and heavy capital inflows are also positive parts of the growth outlook. Rather than signaling a slowdown, the inversion of the yield curve -- "Greenspan's conundrum," in which bond yields are low despite solid growth and rising inflation -- is probably the result of this deep underestimate of the U.S. growth outlook, plentiful liquidity, and a backward-looking deflation premium for bonds, the reverse of the backward-looking inflation premium that kept bond yields unusually high in the 1980s.The common perception is that Americans drive the trade deficit in an unhealthy way by spending more than we produce. To make up the difference, foreigners ship us things on credit. This sounds bad, but should be evaluated in terms of our demographics, low unemployment rate, attractiveness to foreign investment and rising household savings.The recent surge in the U.S. trade deficit reflects, in part, the unprecedented shift in the demographics of the world's large economies. The under-60 U.S. population is expected to grow for at least 50 years while the under-60 populations in Japan and Europe are already declining and in China will turn down within a decade. They need bonds while Americans need capital. They want to save more than they invest in their own economies, and are eager to help us invest more heavily (through their purchase of bonds.) This makes good demographic sense. Older investors (concentrated abroad) need steady returns, lending to younger generations through bank deposits, bond purchases and life insurance premiums (which are reinvested in growth). Younger people (concentrated in the U.S.) need cash and debt for college degrees, houses and business startups. This creates a healthy synergy across generations and across borders.Like young households, many companies also spend more than they produce, using bonds and bank loans, some from foreigners, to make up the difference. They add employees, machines, supplies and advertising before they produce. Growing corporations are expected to be cash hungry. This leverage is treated as a positive for companies but a negative for countries, a key inconsistency in popular economics. Rather than paying the debt back, the growing company rolls the debt over and adds more, just as the U.S. has been doing throughout most of its prosperous economic history. Part of each additional bond offering puts the company and the U.S. in the position of investing more than we save, drawing in foreign investment and contributing to the trade deficit.With all the negativism about the U.S. economy, it's easy to forget its attractiveness. Foreigners are as eager to invest in the U.S. as we are to buy goods and services from them -- it's a two-way street. Our 10-year government bonds yield 4.6% per year versus 1.6% in Japan, while our government debt is 38% of GDP versus 86% in Japan. The comparisons with Europe are not as extreme as Japan's, but still heavily favor the U.S.While the net foreign debt of the U.S. is growing (the result of capital inflows), household net worth is growing faster, meaning foreigners are investing in the U.S. too slowly and conservatively to keep up with our growth. Their capital mingles with domestic savings, providing $2.7 trillion of net international capital to combine with $27 trillion in net U.S. household financial savings as of Sept. 30.The already-large foreign demand for investments in the U.S. is likely to grow from here, putting upward pressure on the trade deficit even if foreign growth continues to accelerate. The U.S. offers a relatively high and steady return on investment -- high because of the innovation and growth taking place here, steady because the commodity and manufacturing parts of many businesses are increasingly done abroad, reducing the volatility in U.S. growth. Equally important, the demographics of the world's large economies are shifting rapidly in favor of the U.S.The trade deficit is the mechanism allowing consumption and investment in the U.S. to grow faster than in Europe and Japan. The issue for the U.S. is whether it's worth the interest costs. It's the same question facing a small business: Should it borrow money to expand the payroll, train employees, buy land and machines, conduct R&D, build inventory? Profit and credit-worthiness help make the decision.The post-election dollar weakness pleased those who still think the U.S. is heading in the wrong economic direction. They advocate a weaker dollar as medicine for the trade deficit, often blaming it for more economic problems than we actually have.But the trade deficit, around for hundreds of years of solid American growth, doesn't justify the inflation risk from dollar weakness or the growth risk from protectionism. And the trade deficit probably wouldn't respond to a weaker dollar anyway -- yen strength hasn't dented Japan's trade surplus, and it took a recession to create our last trade surplus in 1990-1991.The swing vote on the dollar, and probably the controlling vote, is Fed policy. For now, this leaves unresolved the market debate over whether the U.S. will encourage dollar weakness and inflation in an effort to fight the trade deficit. More likely the Fed will fight inflation, strengthening the dollar, and leaving the trade deficit dependent on U.S. growth and demographics -- right where it should be.Mr. Malpass is Bear Stearns's chief economist.

David Malpass rightly argues that the U.S. trade deficit is a sign, not of American economic weakness, but of vigor ("Embrace the Deficit," December 21). To further strengthen his case he might have pointed out that in 102 of the 120 months of that most economically depressed decade, the 1930s, the U.S. ran trade surpluses. On an annual basis, America had a trade surplus for nine of the ten years of the 1930s (with 1936 being the only year of a trade deficit). For the whole of that decade, the U.S. ran a significant trade surplus. Exports over those dreary ten years totaled $26.05 billion while imports totaled only $21.13 billion.

Clearly, just as a trade deficit is no sign of economic malaise, a trade surplus is no sign of economic vitality.

Even though I like the general logic of the piece, I do find myself wondering if the analysis is blurred a bit when it does not distinguish foreign capital inflows to buy US bonds (i.e. finance govt. debt) and foreign capital investment.

As the existence of a nearby thread dedicated to the very subject indicates, I also wonder about WTF is going on with the dollar.

On a purchasing power parity basis, the dollar is seriously UNDERvalued in Europe. For an American to travel in Europe now is very expensive. What is that about? Why is the dollar threatening to break even further to to new lows viz the Euro? Is there NO relation between the balance of trade/capital inflows and the exchange rate of the dollar?

German Chancellor Angela Merkel arrives in Washington on Thursday for talks with U.S. President George W. Bush. Up for discussion is everything from energy security cooperation to relations with Russia. All are important, all will be given their due, but one item on the agenda holds out the possibility of being truly revolutionary: trade.

In a Financial Times article published Jan. 2, Merkel waxed philosophic about her intent to convince the American president of the benefits of coordinating policy on things such as joint financial market regulations, stock exchange delisting rules, intellectual property rights, and mutual recognition of technical standards. We can almost see Bush's eyes glazing over.

But such talks are not just about the technical i-dotting and t-crossing that makes for an economic relationship. Merkel is much more ambitious than that. She wants to see the United States and European Union merge into a single trans-Atlantic common market that would include roughly 800 million people and a combined gross domestic product of half the world's economic output.

The obstacles to such a trade grouping are hardly minor. First, Merkel has to convince the Bush administration that her method -- deeply integrating the technical aspects of economic regulation -- is the way to go, rather than Washington's preferred method of simply brokering free trade agreements. After all, such relatively invasive techniques are similar to (if not flatly modeled on) the European Union's own internal regulatory structures rather than Washington's traditional sovereignty-protecting approaches.

But adopting such an approach may well prove critical to overcoming European opposition to the idea of a trans-Atlantic free trade agreement (TAFTA). Many European leaders fear that allowing unrestricted competition with the United States without inducing the Americans to merge at least some of their regulatory processes with Europe would give the Americans the ability to drive Europe out of legions of markets. TAFTA has, after all, been attempted before -- and while the idea was warmly received in the United States, it was ultimately derailed and defeated in Europe. And by "Europe," we mean "France."

Two things are different this time. First, pushing the regulatory approach should at least give Merkel the ability to ensure her fellow Europeans do not reject the idea out of hand. Second, France is changing. By the time of the EU-U.S. summit in May and the EU heads of government summit in June, France will have its first leader in a generation who does not subscribe to the reflexively anti-American geopolitics of Charles de Gaulle.

Which means that the greatest obstacle remaining for Merkel's TAFTA plan could well prove to be ... Merkel. Successful EU presidencies -- they are only six-month terms -- are generally characterized by agendas limited to one or two extremely focused items. Launching TAFTA talks (and remember that all 27 EU states have to agree unanimously for this to happen) is a hugely ambitious task, and it is only one of many that Merkel has set for herself. Also on her agenda is navigating a potential crisis in Serbia, figuring out what to do about Bosnia, helping relaunch Middle East peace talks, restarting negotiations with Russia on a partnership deal, solving that Africa hunger problem, and, oh yes, figuring out a way to salvage the twice-defeated European constitution -- all while Merkel's own coalition government is not exactly on the best of terms with itself. Such a towering list is a large order even for a German chancellor.

Still, a key theme of Stratfor's 2006 annual forecast was that Germany's return to being a "normal" country will reshape international geopolitical dynamics. If the good chancellor can achieve even a fraction of her agenda, we will have written an understatement.

If the Stratfor analysis of China is correct, it would seem that China's economy could be headed for a big fall at some point, probably with serious political disruption.

Also, there is the matter of China's declining population due to the one-child-per-family policy. Does anyone have any data on this?

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China: Using Political Tools to Fix the EconomySummary

The Chinese government is trying (and failing) to rein in economically questionable activities that are driving up prices without producing healthy growth. Beijing is discovering that traditional economic and financial tools are not serving it well. Next come the more brutal measures.

Analysis

For years, the Chinese economy's problem has been the irrational allocation of capital. In order to stimulate growth, the government has long artificially suppressed the real interest rates charged on loans from state banks -- often to the point that, once inflation is taken into account, those loans can be repaid for less than they are worth. That encourages growth and development, but not in a sustainable way. Many Chinese firms can only survive so long as that flow of artificially cheap credit is sustained.

Such a strategy has a number of downsides, but the main disadvantage is the rampant proliferation of firms that do not operate at a profit. These firms pile up mountains of bad debts which probably total about half of China's total gross domestic product. Yet, because profit does not matter and capital is easily attained, these firms can afford to expand operations endlessly. This expansion then creates sustained and growing demands from these firms for everything from concrete to electricity. The dramatic price hikes in most commodities on the global market these past four years can be laid at the feet of these noncompetitive Chinese firms and their demand. And of course, we all know how foreign governments feel about credit-subsidized Chinese firms dumping their products on international markets.

China's Politburo is well aware that the core dysfunction of its country's economic model is subsidized credit, and Beijing is trying to root out the problem. There are two ways to do this. The first and simplest is to increase interest rates, which makes firms less likely to take out new loans because they have to pay back more than they borrow.

The second strategy was attempted Jan. 5 when the People's Bank of China, the country's central bank, increased the country's reserve requirement ratio by 0.5 percentage points to 9.5 percent. The reserve requirement ratio is the portion of a bank's assets it must hold in reserve, with the remainder (90.5 percent in this case) available for disbursing to customers as loans. If the ratio goes up, banks have to restrict lending. The theory behind the increase is that banks will only lend to firms with relatively sound business plans (which, therefore, would be able to repay their loans).

Neither step is working. Borrowers remain convinced that the government will bail them out (after all, most of the borrowers are government firms), and without a mindset shift among the borrowers, interest rates hikes have a negligible impact. Similarly, in a system where local government officials often control both the state-owned companies wanting the loans and the state-owned banks making them, adjusting the reserve ratio produces only marginal results. Indeed, rate hikes steadily accrued in 2006 to no result, and the Jan. 5 ratio increase was the fourth in seven months.

This should not come as a surprise to the government. After all, Beijing ordered the suspension of all lending activity for a few days in April 2004, but to no avail. Anywhere else in the world, this would have caused an instant recession (if not depression) -- but not in China. The Chinese economic juggernaut lumbers on, with the country's 33.4 trillion yuan ($4.28 trillion) in deposits providing the fuel for annual growth of more than 10 percent.

Traditional economic policy tools -- whether taxes or regulations -- have minimal impact on the Chinese system. And when economic tools do not work on economic problems, Beijing has no choice but to pull a different policy set out of the toolbox. Rates and ratios give way to purges and prosecutions.

This already has been seen in the intensified anti-corruption drive in which Beijing sacked Chen Liangyu, Shanghai's Communist Party secretary and a Politburo member, in September. Chen's dismissal was part of a larger purge in the booming coastal city, which rooted out not only local officials with questionable management skills but also cadres left over from the time of former President Jiang Zemin. The anti-corruption drive has been used elsewhere as well, reaching into Macao and, more recently, into the Shandong peninsula, one of the areas Beijing wants to develop economically in the future.

Ahead of the 17th Congress of the Communist Party of China later this year, Chinese President Hu Jintao is cleaning out political and party officials who oppose his economic (and social) policies, and laying the framework for a more loyal and responsive provincial and local leadership. Hu hopes this will lay the groundwork for an expansion of his "New Left" policies, through which he hopes to reshape the Chinese economic landscape, dictating where certain industries will be concentrated and which entrepreneurs can operate in which sectors.

While such close government-business cooperation allowed a country like South Korea to boom in the 1970s and '80s, China will be trying this on an unprecedented scale -- and will need full political control in order to restructure the freewheeling Chinese economy. In reality, such a strategy is more political than economic in nature, as it seeks not only to revamp the country's corporate environment but also to radically reshape the ways in which Chinese citizens and businessmen act and interact.

To call the process jarring would be an understatement of the grinding conflict to come. Years of attempting to change China's corporate culture using traditional economic tools resulted in the death or disappearance of thousands and a steadily deteriorating security environment. Hu now knows he needs to attack the problem at its source -- the Jiang cadre that created the culture in the first place -- and if he has been paying attention, he knows he cannot be soft.

In his op-ed column on these pages this week, President Bush made some news by underscoring his opposition to raising taxes. We were certainly glad to hear it, and to publish it, because by our lights the tax cuts and economic growth that has followed are his most notable domestic achievements (give or take a Supreme Court Justice).

That growth was underscored again with yesterday's buoyant jobs and income report for December. Job growth exceeding expectations at 167,000 and the jobless rate held at a very low 4.5%, despite a slowdown in manufacturing and construction. Since the Bush tax cuts on dividends and capital gains passed in mid-2003, the economy has created 7.2 million new jobs according to the survey of business establishments, and an additional 1.2 million in the more variable household survey.

As for the inevitable political complaints that these new jobs are all lousy, average hourly non-supervisory wages have now climbed 4.2% over the past 12 months, or twice the official rate of inflation. With flat or falling energy prices, and a tight labor market, real wages are also starting to show impressive gains.

Meanwhile, tax revenues continue to roll into the Treasury and state coffers. Federal receipts rose by 14.6% in fiscal 2005, another 11.8% in 2006, and kept rising by 9% in this year's first two months despite slower GDP growth. The budget deficit, in turn, has fallen by $165 billion in two years, and including state surpluses is now down to about 1% of GDP, which as an economic matter is negligible. Tax revenues as a share of the economy are also back above 18.5%, which is their modern historical norm.

This record is so impressive that liberal critics have been forced to ignore it and focus on other alleged outrages, such as "inequality," or CEO pay, or some vague prediction of future doom. And, yes, the future is unpredictable. But in the field of economics there are few more definitive tests than the results from the tax cuts of 2003. Critics predicted disaster, supporters the opposite, and the supporters can point to more than three years of prosperity as vindication--despite $70 oil and $3 gasoline, and lately despite the worst housing slowdown in 15 years. However, those lower tax rates are set to expire at the end of 2010, and the Democrats who now control Congress want them repealed. The "pay-as-you-go" rules that the House just passed would make their extension all but impossible. What this means is that if Congress merely fails to act, the tax cuts expire and the economy will be hit with one of the largest tax increases in history in 2010.

The dividend rate would snap back to 39.6% from 15%, the capital gains rate to 20% from 15%, and the top marginal income tax rate to 39.6% from 35%. Marginal and average tax rates for the middle class would also increase, returning to the Clinton-era levies that had driven taxes as a share of GDP to a postwar high of 20.9%.

Now in the minority on Capitol Hill, Republicans can't do much about this. But it certainly poses a dilemma for Democrats--all the more so because they must also cope with the rising burden of the Alternative Minimum Tax. The AMT--created by Democrats in 1969 to capture a few millionaires--will engulf some 23 million taxpayers this year without a change in law.

This week, the new Democratic Chairman of the Senate Finance Committee, Montana's Max Baucus, called the AMT a "monster in the tax code" and introduced a bill to repeal it. The only catch: Under Congress's wacky "static revenue" analysis of calculating the impact of tax cuts, AMT repeal would "cost" the Treasury as much as $1.2 trillion over 10 years. Maybe they can find that much in Congressman William Jefferson's freezer.

Our guess is that Democrats will try to finesse all this in the near term. With President Bush now saying he'll oppose a tax increase, they'll be wary of voting for one that would be vetoed and provide Republicans with an issue in 2008. So perhaps they'll try a one- or two-year AMT fix to get them past 2008, while waiting for their Presidential nominee to advance a more detailed tax proposal. Most likely, that would involve a pledge to keep the lower Bush rates for the "middle class," while raising rates on "the rich." Bill Clinton played that tune all the way to the Oval Office, only to raise taxes on everybody once he got there. It'll be fascinating to see if voters give his wife, Senator Hillary Rodham Clinton, the same leave if she's the Democratic nominee. In any event, what we seem headed for is a two-year national donnybrook over taxes and income that will be decided by the voters in November 2008.

Jan. 8 (Bloomberg) -- Marc Faber, who predicted the U.S. stock market crash in 1987, said global assets are poised for a ``severe correction'' and it's time to sell.

``In the next few months, we could get a severe correction in all asset markets,'' Faber said in an interview with Bloomberg Television in New York. ``In a selling panic you should buy, but in the buying mania that we have now the wisest course of action is to liquidate.''

Faber, founder and managing director of Hong Kong-based Marc Faber Ltd., advised investors to buy gold in 2001, which has since more than doubled. His company manages about $300 million in assets.

The bullish outlook of traders in everything from bonds, equities and commodities to real estate and art suggests valuations are peaking, Faber said. Last year, the Morgan Stanley Capital International World Index of developed stock markets jumped 18 percent, while a survey of Wall Street's biggest bond- trading firms predicted U.S. Treasuries will post the best gains in five years during 2007.

``I am not a great buyer of assets now,'' Faber said. ``We may be in a situation where consumer-price inflation comes back and will have a negative impact on the valuation of assets.''

Faber, publisher of the Gloom, Boom & Doom Report, does have some favorites. Singapore and Vietnam are his top picks in Asia because stocks in Singapore aren't ``terribly expensive compared with interest rates'' in the city-state, while Vietnam's equities have ``incredible potential in the long run.''

Vietnam, Singapore

Vietnam's Ho Chi Minh Stock Index more than doubled last year and was Asia's best-performing benchmark. Singapore's Straits Times Index climbed 27 percent, beating a 15 percent increase in the Morgan Stanley Capital International Asia-Pacific Index.

So far in 2007, Vietnam's index has surged 10 percent, again leading gains in the region, and Singapore's is up 0.6 percent. The MSCI has dropped 1 percent.

Faber recommends investors steer clear of shares in the world's biggest developing economies after the emerging markets in 2006 outperformed their developed counterparts for a fifth straight year.

``Emerging markets could get kicked in the next three months so I'd be careful of buying Russian shares,'' Faber said. ``I'd also be careful of buying China and India shares now.''

Russia's dollar-denominated RTS Index surged 75 percent last year, while the Hang Seng China Enterprise Index, which tracks Hong Kong-listed shares of Chinese companies, jumped 94 percent. India's Sensex Index, which more than quadrupled in the past five years, is valued at 25 times estimated earnings.

Thailand, Japan

Faber also advises investors stay away from shares in Thailand, where he and his family are based. The nation's SET Index has been the world's worst-performing benchmark in the past month, sliding 15 percent as currency controls introduced by the central bank and bombs in Bangkok spooked investors.

``Valuations in Thailand are very inexpensive but I wouldn't buy tomorrow,'' said Faber. `` We have some political problems in Thailand right now. I'd wait for a couple of months.''

The SET is valued at 10 times estimated earnings, the lowest among 14 Asia-Pacific markets tracked by Bloomberg. MSCI's regional index is valued at 18 times.

On a more positive note, Japanese stocks may prove good bets this year, Faber said. The Nikkei 225 Stock Average climbed 6.9 percent in 2006 and the broader Topix index added 1.9 percent, the smallest gains among benchmarks for the world's 10 biggest markets.

U.S. Strategists

The U.S. outpaced Japan last year, with the Standard & Poor's 500 Index climbing 14 percent and the Dow Jones Industrial Average surging 16 percent.

Strategists at 14 of the biggest Wall Street firms all estimate that U.S. stocks will advance this year. The last time they were in agreement was for 2001, when the S&P 500 dropped 13 percent.

``It's going to have to be something unexpected and somewhat dramatic'' to spur the type of pullback that Faber predicts, according to Wayne Wicker, chief investment officer at Vantagepoint Funds in Washington, which has about $28 billion in assets. ``Given the current environment we see today, I don't see anything imminent, other than a huge amount of money chasing deals, as a real negative.''

Last year saw a record $3.68 trillion in takeovers, led by AT&T Inc.'s $86 billion purchase of BellSouth Corp., according to data from Bloomberg. Mergers and acquisitions will rise by at least 10 percent this year, analysts at Deutsche Bank AG, JPMorgan Chase & Co. and Bank of America Corp. forecast.

Gold, Oil

Faber said gold should rally further on expectations that supply of the precious metal will decline and demand for it will increase to hedge against inflation. Gold climbed 23 percent last year, its sixth year of gains.

``The price of gold will continue to go up and probably very substantially,'' Faber said. ``In the long run, it's very clear that central banks are basically increasing the supply of money and the supply of gold is obviously very limited.''

Oil prices are also tipped to rise as political instability in the Middle East and other petroleum-producing areas threatens supply and global demand increases. Crude oil in New York added less than 0.1 percent to $61.05 a barrel in 2006, after tripling in the previous four years.

``Everyday the world is burning more oil than new reserves are added,'' Faber said. ``You wont see $12 dollars again'' for every barrel of oil. ``The trend is likely more to be upside because demand in Asia is going to double over time.''

Last week Nancy Pelosi's House Democrats passed what Washington insiders call "pay-go" budget rules. Pay-go requires that any new entitlement programs or tax cuts must be "paid for" with other entitlement cuts -- which, of course, never happen in Washington -- or with tax increases.

The new rules passed pretty much as a straightline party vote, though some 40 Republicans voted with the Democrats for this tax hike mechanism. And a few liberal Democrats criticized the measure because they fear that even this flawed budget discipline might prevent them from increasing spending as fast they would like.

But no worries, say a number of liberal commentators, who are openly advertising the idea that canceling the Bush tax cuts offers the Democrats a big cash drawer to raid under pay-go. Berkeley economist and blogger Brad DeLong argues: "Restoring pay-as-you-go means that the Bush tax cuts expire at the end of this decade...The embrace of pay-as-you-go orders up a $300 billion rise in taxes at the end of this decade. That's a significant amount of deficit reduction all by itself, and a very significant change from Bush administration idiocy."

Democrats are also eyeing bringing back the death tax to fund new spending programs. Reviving the death tax, which expires in 2010, would raise about $28 billion a year, according to the Brookings Institute.

Democrats believe that just by doing nothing and letting all the Bush investment tax cuts expire in 2010, Congress will have about $88 billion a year more money to play with. Of course, this really is just budgetary funny money -- because canceling the Bush tax cuts would likely do so much damage to the economy that federal revenues would actually shrink rather than grow, even with higher tax rates. Notice how federal revenues have soared since Mr. Bush's lower capital gains and dividend tax rates took effect.

"We're pretty certain the House Democrats see pay-go as not an instrument of fiscal discipline but as a tool to make raising taxes much easier," says GOP Rep. Mike Pence, who helped lead the opposition to the new pay-go rules. Now you know why pay-go is so popular in Washington.

The hated alternative minimum tax will hit about 19 million taxpayers this year, up from 1.3 million who got socked by Uncle Sam's shadow tax system in 2000. We've noted many times that voters in Democratic states in the Northeast and California tend to be the most heavily impacted by the AMT and that if Congressional Democrats don't change this system, their own voters will soon be walloped with the biggest middle-income tax hike in American history. That's why we call the AMT the "Blue State" tax.

Now a new study by the Tax Foundation reveals the 20 Congressional districts with the highest percentage of voters who are impacted by the AMT. Guess what? This is also the "Blue District" tax as well. The study finds that nearly half of the top 20 districts are in New York -- which just happens to be Ways and Means Committee Chairman Charlie Rangel's home state. New Jersey and California are next in line in terms of having the highest percentage of AMT victims. Thirteen of the top 20 congressional districts with the highest percentage of AMT voters have a Democratic congressman -- including the top four. The award-winning district with the most AMT filers is that of Rep. Nita Lowey. In her suburban New York district, some 14% of all filers pay an AMT penalty averaging $5,885 a year.

One reason that so many New York, California and New Jersey taxpayers get kicked in the rear is that these are high-income (and high cost-of-living) states, with high state and local taxes. Under the AMT, these tax filers lose their write-off for their hefty state and local tax payments. What's more, because the AMT threshold wasn't indexed for inflation and wasn't adjusted for the Bush cuts in regular income tax rates, the AMT is set to clamp its fangs on a much larger section of the taxpaying public soon, reaching 20% of all filers by 2010. That means if Washington doesn't do anything to alleviate the coming avalanche, governors like Elliot Spitzer of New York and Jon Corzine of New Jersey will be under strong pressure to cut their own tax rates to cushion the blow or else risk a wholesale flight of their highest earners and most prosperous industries to other states.

Surging RevenuesJanuary 17, 2007; Page A18The myth persists in some media circles that the federal budget deficit is "surging" or ballooning or something terrible -- all of which is served up as ammunition for those in Congress who want a tax increase. At the risk of being drummed out of the guild, we thought you'd rather have the real story.

The deficit has in fact declined by some $165 billion over the past two fiscal years, and according to the most recent data has continued to fall in the first quarter of fiscal 2007. The latest Treasury estimates for January show that tax receipts in December were $18 billion higher than a year earlier, helping to boost the budget surplus for the month to $40 billion, up from $11 billion a year ago. December is typically a good month for revenues due to year-end tax payments.

Meanwhile, for the first three months of fiscal 2007 through December, revenues climbed 8.1%, building on double-digit revenue increases in the previous two years. Corporate income taxes were up a remarkable 22.2% in the first fiscal quarter, showing that the government continues to grab a nice chunk of the rising business profits that so many of our politicians like to deplore. Individual income taxes rose 8.8%, thanks to strong wage and salary growth. Much of this revenue comes from "the rich," believe it or not.

In the most surprising budget news, federal spending was nearly flat in the first fiscal quarter. This was despite a 22.1% increase in Medicare spending due largely to the new prescription drug benefit, and a 10.7% increase in defense. Those increases were offset by lower spending for flood insurance and disaster assistance compared with the peak of post-Katrina payments a year ago. So the first quarter deficit was $85 billion, down sharply from $119 billion a year earlier.

All in all, despite huge outlays for wars in Iraq and Afghanistan, the nation's fiscal picture is brightening. We hate to ruin the press corps's day with such cheerful news, but there it is.

The charts referenced in the article may not come through here in the forum, but I think the larger point is clear.=======================

Conversations with Dr. Gold

by Michael NystromFebruary 5, 2006

They say that copper is the only metal with a PhD in economics, because it has such an excellent record in forecasting future business activity. Much has been made recently about Dr. Copper and his preliminary diagnosis of an impending recession, but what many don't realize is that the king of metals -- gold -- also has a PhD. However, if Copper's doctorate is in economics, Gold's expertise is more along the lines of philosophy, and his degree has been awarded by the world's oldest, most venerable of schools: the school of hard knocks.

Dr. Gold still teaches at the school of hard knocks -- the same old classes that have been in session since the dawn of civilization. Dr. Gold lectures on the subjects of beauty, value, responsibility, and the rule of law. One of his most popular courses -- offered regularly -- is on the subject of inflation. Dr. Gold is a kind and patient teacher, repeating his lessons again and again for beginning students, never tiring but unmercifully strict. He will never fail to pull cocky young upstarts who think they they know better back into line -- sometimes quite violently.

I had a few conversations with Dr. Gold this weekend at the Boston Public Library. Many people don't know it, but most big city libraries subscribe to a number of excellent market letters. Boston Public has over 20, and every couple of weeks I like to go down and catch up with what some of the great market thinkers are thinking. Nearly all of these thinkers are long-time students, in one way or another, of Dr. Gold.

Richard Russell is an old timer. His January 24 Dow Theory Letter is a great one. He details how much investing has changed since he began, just after the War when the memory of Depression was still fresh in people's minds. Back then, nobody wanted a stock unless it payed a dividend - almost the complete opposite of today. I'll have more to say about that in future articles ( sign up here to be notified) But of particular interest was Russell quoting another old timer, Ian McAvity on one of Dr. Gold's many lessons: Think of the Dow as a tradable ETF. In August 1929, your grandfatehr sold one unit of the Dow and bought 18 and 1/2 ounces of gold. Three years later, when the Dow/gold ratio bottomed at 2:1, he sold those 18 ounces of gold and bought back 9 units of the Dow with the proceeds.

Those nine units reached another peak in 1966, when the ratio hit 28:1. Now your father exchanged those 9 Dow units for 252 ounces of gold. In January 1980, the ratio got to an almost unprecedented 1:1, so he converted those 252 ounces of gold into 252 units of the Dow.

Come 1999 with the ratio at an unprecedented 43.85:1 level, the prudent family converted those 252 units of the Dow into 11,050 ounces of gold! No trades were based on the price of gold or the level of the Dow...It's just a simple question of how many ounces of gold is the Dow trading for in the market. This little fable started with 1 unit of the Dow at a peak in 1929. Two tops, two bottoms and five trades later, its 11,050 ounces of gold in 70 years. Which would you rather have today? 11,000 Dow points, or 11,000 ounces of gold?

Of course it is just a story, but as Russell points out, it shows the importance of relative valuation, patience, and -- for lack of a better word -- the fashions of investing. Fashions come and go among investors, so don't get too attached to a trend. Once upon a time (back in Russell's early days) it was bonds and dividend stocks that everyone wanted. Later it was growth stocks, then real estate. But sooner or later, old styles come back into fashion. They always do.

Another lesson from Dr. Gold comes by way of December's Elliott Wave Theorist on the Silent Crash. This one was not available at Boston Public, but you can download the entire report and watch the video edition for free until Thursday. In this report, Robert Prechter points out that the nominal Dow peaked at 381 in September 1929, and today it is hovering somewhere around 11,500, a 30X increase over 77 years. Not bad, right? But amazingly, measured in gold, the recent Dow high's are actually right about where they were at their 1929 peak! Unbelievable but see for yourself:

Prechter says: It took 18.5 ounces of gold to buy the Dow on September 3, 1929. On May 10, 2006, it took 16.5 ounces of gold, so it is actually cheaper. Now, you might think this is just an academic comment, but it's crucial to understand that there has been very little net manufacturing growth in the United States over that period. It's hard to believe, but it's being masked by tremendous credit inflation supported by the Federal Reserve and carried out by the banking system. Or as Dr. Gold would put it: One dollar won't buy what it did in 1929, but one ounce of gold (about $20 at the time) sure will (about $650 today)! This is an incredibly important chart, and there are others that go along with it showing the hidden destructiveness of unchecked credit creation and the likely outcome.

Along these same lines, Dan Amoss, in the February issue of Strategic Investment, has some interesting teachings from Dr. Gold via a story about the current "Goldilocks" economy. As the Goldilocks scenario goes, Chairman Ben supposedly has the US economy running "just right," just like Goldilocks, who broke into the three bears' house and ate the bowl of porridge that was "just right." (huh?) But Amoss notes that the Goldilocks story has a tragic ending. When the bears come home and find her sleeping in their house, they kill young Goldilocks, rip her to shreds and eat her (or just scare her and chase her away, depending on who's telling the story). After all, she has no right trespassing in their house and eating their food, even if she is just a naive little girl. That's how things go in the school of hard knocks. Apparently Goldilocks wasn't one of Dr. Gold's better students.

Amoss goes on to say: Taking this metaphor to a more plausible conclusion -- the Federal Reserve has broken into the house, sat in the chairs, ate the porridge, and slept in the beds of every individual saver of US dollars. This institution constantly injects new floods of cash into the banking system by "monetizing" government liabilities (mostly Treasury bills). With each new dollar created, the value of each existing dollar held by savers declines in value. This is part of the story that is being told by the chart above. The Fed is apparently another one of those upstart young students that Dr. Gold is going to have a word with one of these days...

But there is more to the story: Only two of the Dow's original 1929 components remain in the index today. The rest have either shriveled up and been kicked out of the Dow, been acquired by foreign or domestic companies, or have simply disappeared. Poof. Bankrupt. Gone. Many of today's industrials are not even industrials at all. Can you honestly call American Express, AIG, Citigroup, JP Mogan, Disney, McDonald's, Coke, Home Depot and Wal-Mart "industrial" stocks?

The only two that remain from '29 are GE and GM, and it is questionable how much longer GM will last. The changes to the index reflect the changing nature of the US economy. Chrysler for example, a member of the '29 Dow, is now owned by a German company and just today announced that it will lay off 10,000 American workers and close at least two more US plants. As American manufacturing has crumbled, the US has moved increasingly towards a service economy, with special emphasis on financial services. Four of the Dow's current 30 stocks are financial services firms. In the long run, the question still remains -- at least in my mind -- if this kind of a service-based economy can create real wealth, or is it all just shuffling paper? Warren Buffett said it another way, "If you get in early on a chain-letter, you may make money, but no wealth is created."

Speaking of Buffett, let's pop on over and read a few pages of the Intelligent Investor, by Benjamin Graham (most certainly available at your local library). Remember that Graham was Warren Buffett's mentor, and Buffett calls this the greatest investment book ever written. A few of the most important insights found in the book include (from the introduction): The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists. The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be. The secret to your financial success is inside yourself. If you become a critical thinker who takes no Wall Street "fact" on faith, and you invest with patient confidence, you can take steady advantage of even the worst bear markets. By developing your discipline and your courage, you can refuse to let other people's mood swings govern your financial destiny. In the end, how your investments behave is much less important than how you behave. The last point very critical. Dr. Gold couldn't have said it better himself. Don't take anything on blind faith. The best (some say the only) education comes the hard way, from the school of hard knocks. The next best way is to study history, putting special emphasis on the teachings of Dr. Gold.

Some excellent food for thought points in that post. I learned a little because I don't follow gold. I've always seen gold investment as a bet against productive investments. I prefer real estate for performance and as a hedge against monetary risk.

Nitpicking the first point about copper, I would point out that glass and plastic fiber optics can replace copper for voice and data, and plastic can replace copper for plumbing. My plumber in the highest town in Colo. no longer stocks copper, not just because of price but also because of the freeze resilience of new plastic: http://www.wirsbo.ca/default.php?id=32. Copper may still have an importance in the economy, but not exactly the same as it once was.

The Fed was criticized: "With each new dollar created, the value of each existing dollar held by savers declines in value." - Yes, but at a very low and controlled rate. In my study of the Bernancke Fed, I find they are (also) scared to death of deflation. When inflation hits zero, they have no tools, so the mission is to keep inflation low but the target is never below 1% per year. The article does some analysis back to the 1920's (also takes some perfect trough buys and perfect peak sells for illustration), but for current, managed investments, I think low, consistent inflation is no threat to otherwise good investments.

The list of Dow companies changing in nearly a century makes a point, but an index fund would make all those adjustments. Also seems to me that the investor who was in Sears Roebuck then would be in Microsoft now, for example, with or without the updates to the Dow.

I see no threat or significance to the shift from emphasis on manufactured goods to a so-called service economy, unless there was a shortage of manufactured goods. We may think of fast food workers as service but a service worker might also be a heart surgeon. Value added is the key IMO.

It's the best of times. It's the scariest of times. Last year, U.S. exports, industrial production, real hourly compensation, corporate profits, federal tax revenues, retail sales, GDP, productivity, the number of people with jobs, the number of students in college, airline passenger traffic and the Dow Jones Industrial Average all hit record levels. For the third consecutive year, global growth was strong, continuing to lift (and hold) millions of people out of poverty. From 30,000 feet, heck from 1,000 feet, it sure looks like the best of times.

In relative terms, the first five years of the current recovery have been much better than the first five years of the 1990s recovery. But all this has not softened the pessimism of many pundits and politicians who are either unimpressed or expect the whole thing to come crashing down any minute. That is, unless the government firmly grabs the reins of the global economy and steers it clear of disaster.

Many believe that the debate is over on global warming, nationalized health care, tax hikes, rich-versus-poor, the trade deficit and "obscene" oil company profits. Forgotten in this rush to pass judgment on capitalism is the fact that the last two times government seriously tried to control the U.S. economy -- in the 1930s and in the 1970s -- they made a terrible mess of it.

In the 1930s, the Smoot-Hawley Tariff Act caused a collapse in global trade, while the Fed allowed the money supply to shrink by one-third. Government regulation in the 1920s prevented banks from branching, which caused more than 10,000 to fail in the 1930s, deepening and prolonging the Great Depression. Herbert Hoover's tax hikes were icing on the cake, capping off a perfect storm of D.C. policy mistakes.

It took another 35 years, and a nice run of prosperity, but Washington finally gathered the courage to try this again. Between 1965 and 1981, Great Society welfare and health-care programs, wage and price controls, inflationary Fed policy, 70% marginal tax rates, 50% capital-gains tax rates, and highly regulated energy, airline, banking and trucking industries created severe problems. The Misery Index (calculated by adding inflation and unemployment) rose to 21.9% in 1980 (today it is 7.2%).

One of the worst mistakes of the 1970s was a National Energy Plan. On April 18, 1977, in a nationally televised speech, President Carter said, "World oil production can probably keep going up for another six or eight years. But some time in the 1980s it can't go up much more. Demand will overtake production."

President Carter's White House economists worried about "environmental damage and the risks to national security and to future economic activity posed by energy imports." To fix these problems, the Department of Energy (DOE) was created while the Congress and president pushed forward windfall profits taxes, price caps, subsidies for solar energy, tax breaks for using coal, and direct spending on synthetic fuels.

Not only did all of this fail to stop imports or the use of fossil fuels, it was also the source of economic pain. Part of the problem was faulty forecasts. Rather than peaking in the mid-1980s, the latest DOE estimates predict peak oil production no earlier than 2021, but possibly as late as 2037, 2067 or 2112, depending on assumptions.

The cost of government intervention is always underestimated in the midst of political battles, while the benefits are always overestimated. Impeding the free market alters the course of economic activity in ways that cannot fully be understood in advance. For example, tax subsidies for using existing solar technology diminish incentives for research and development, just like welfare payments undermine the willingness of many recipients to work or go to school. Why give up a sure thing for a future that is uncertain?

The U.S. is subsidizing ethanol, which pulls billions of dollars of investment capital away from other areas of the economy. When government picks what it thinks should be the winner, it saps resources from other ideas and potential advancements. In the 1960s, the U.K. picked coal and steel, while Japan picked consumer electronics, motor vehicles and exports. The U.K. was wrong. The Japanese got it right. But the odds of any government picking the right strategy, industry or technology are no greater than that of a single company or individual.

The power of a free market is that the odds of success are increased. With tens, or hundreds, of thousands of different entities researching, inventing, producing and distributing, successes not only multiply, but their profits generate resources that allow the economy to absorb the cost of mistakes and failure. It's called diversification. When one company fails, those closely involved are hurt, but not the entire economy. When government is wrong, millions suffer.

Unfortunately, the government reacts to market failure by creating more regulation. Think Sarbanes-Oxley. But the costs of this regulation are almost always greater than the benefits; and Congress tends toward denial when it comes to government failure.

One would think that the unbelievably dramatic turnaround in the economy from the malaise of the 1970s to the boom of the past 24 years would prevent the return of big government. But it appears that a growing number of American politicians, journalists and their constituents have forgotten the awful reality of the 1970s economy. Part of the problem is that people younger than 45 don't have even the slightest idea of how bad it was, or what caused it. They also have no idea that when Margaret Thatcher and Ronald Reagan turned away from socialism in the late 1970s and early 1980s, continental Europe (Germany, France and Italy) kept going. Then while the U.S and U.K. boomed, continental Europe fell behind.

Moreover, many of the more acute economic problems supposedly facing the U.S. are evaporating quickly. My models of the federal budget forecast a $115 billion dollar deficit this year, just 0.8% of GDP, less than half the size expected by the White House, and $57 billion less than the Congressional Budget Office (CBO). Next year, I expect a deficit of $35 billion. A budget surplus in 2009 is likely.

With tax rates low, profits and incomes rising, and strong non-withheld income tax revenues (from IRA withdrawals and capital gains), forecasts of a significant slowdown in revenue growth appear too pessimistic. Many argue that the cost of fixing the Alternative Minimum Tax will reduce revenue growth, but the AMT has been "fixed" in each of the past three years and revenue growth has consistently exceeded expectations. The wild card is spending. My forecast expects $40 billion more in spending than CBO estimates this year, mostly for the Iraq war. But gridlock in Congress should help spending growth to remain in check for the next few years.

Surpluses will change the calculus on tax hikes in dramatic fashion. Any argument to repeal the Bush tax cuts will face a strong headwind. This is great news for investors and the economy. In addition, with unemployment down to 4.6%, and real GDP excluding housing up 4.3% in the past year, many industries face labor shortages. Wages are being bid higher and much like the second half of the 1990s recovery, wage growth should continue to accelerate sharply in the months and years ahead. Data show that this process has already begun.

The economy is still riding a wave of productivity growth, built on the winds of technological change. Computer chips are still getting faster, cheaper and more efficient. Software is becoming more powerful and telecommunication advances are moving at warp speed.

Free-market capitalism is not perfect. But it remains the single most efficient and powerful system for creating wealth, reducing poverty and developing less wasteful ways of organizing output and consuming resources.

With the U.S. seemingly at a political turning point, the next few years are very important. At a similar juncture in 1929, and again in 1965, the U.S. moved toward bigger government. After World War II, and again in the early 1980s, Washington chose less intrusive government. The results speak for themselves. Good times or scary times: It's our choice.

Mr. Wesbury is the chief economist at First Trust Advisors L.P. in Lisle, Ill.

Statement at Hearing of the House Financial Services Committee, February 15, 2007

Transparency in monetary policy is a goal we should all support. I've often wondered why Congress so willingly has given up its prerogative over monetary policy. Astonishingly, Congress in essence has ceded total control over the value of our money to a secretive central bank.

Congress created the Federal Reserve, yet it had no constitutional authority to do so. We forget that those powers not explicitly granted to Congress by the Constitution are inherently denied to Congress – and thus the authority to establish a central bank never was given. Of course Jefferson and Hamilton had that debate early on, a debate seemingly settled in 1913.

But transparency and oversight are something else, and they're worth considering. Congress, although not by law, essentially has given up all its oversight responsibility over the Federal Reserve. There are no true audits, and Congress knows nothing of the conversations, plans, and actions taken in concert with other central banks. We get less and less information regarding the money supply each year, especially now that M3 is no longer reported.

The role the Fed plays in the President's secretive Working Group on Financial Markets goes unnoticed by members of Congress. The Federal Reserve shows no willingness to inform Congress voluntarily about how often the Working Group meets, what actions it takes that affect the financial markets, or why it takes those actions.

But these actions, directed by the Federal Reserve, alter the purchasing power of our money. And that purchasing power is always reduced. The dollar today is worth only four cents compared to the dollar in 1913, when the Federal Reserve started. This has profound consequences for our economy and our political stability. All paper currencies are vulnerable to collapse, and history is replete with examples of great suffering caused by such collapses, especially to a nation's poor and middle class. This leads to political turmoil.

Even before a currency collapse occurs, the damage done by a fiat system is significant. Our monetary system insidiously transfers wealth from the poor and middle class to the privileged rich. Wages never keep up with the profits of Wall Street and the banks, thus sowing the seeds of class discontent. When economic trouble hits, free markets and free trade often are blamed, while the harmful effects of a fiat monetary system are ignored. We deceive ourselves that all is well with the economy, and ignore the fundamental flaws that are a source of growing discontent among those who have not shared in the abundance of recent years.

Few understand that our consumption and apparent wealth is dependent on a current account deficit of $800 billion per year. This deficit shows that much of our prosperity is based on borrowing rather than a true increase in production. Statistics show year after year that our productive manufacturing jobs continue to go overseas. This phenomenon is not seen as a consequence of the international fiat monetary system, where the United States government benefits as the issuer of the world's reserve currency.

Government officials consistently claim that inflation is in check at barely 2%, but middle class Americans know that their purchasing power – especially when it comes to housing, energy, medical care, and school tuition – is shrinking much faster than 2% each year.

Even if prices were held in check, in spite of our monetary inflation, concentrating on CPI distracts from the real issue. We must address the important consequences of Fed manipulation of interest rates. When interests rates are artificially low, below market rates, insidious mal-investment and excessive indebtedness inevitably bring about the economic downturn that everyone dreads.

We look at GDP numbers to reassure ourselves that all is well, yet a growing number of Americans still do not enjoy the higher standard of living that monetary inflation brings to the privileged few. Those few have access to the newly created money first, before its value is diluted.

For example: Before the breakdown of the Bretton Woods system, CEO income was about 30 times the average worker's pay. Today, it's closer to 500 times. It's hard to explain this simply by market forces and increases in productivity. One Wall Street firm last year gave out bonuses totaling $16.5 billion. There's little evidence that this represents free market capitalism.

In 2006 dollars, the minimum wage was $9.50 before the 1971 breakdown of Bretton Woods. Today that dollar is worth $5.15. Congress congratulates itself for raising the minimum wage by mandate, but in reality it has lowered the minimum wage by allowing the Fed to devalue the dollar. We must consider how the growing inequalities created by our monetary system will lead to social discord.

GDP purportedly is now growing at 3.5%, and everyone seems pleased. What we fail to understand is how much government entitlement spending contributes to the increase in the GDP. Rebuilding infrastructure destroyed by hurricanes, which simply gets us back to even, is considered part of GDP growth. Wall Street profits and salaries, pumped up by the Fed's increase in money, also contribute to GDP statistical growth. Just buying military weapons that contribute nothing to the well being of our citizens, sending money down a rat hole, contributes to GDP growth! Simple price increases caused by Fed monetary inflation contribute to nominal GDP growth. None of these factors represent any kind of real increases in economic output. So we should not carelessly cite misleading GDP figures which don't truly reflect what is happening in the economy. Bogus GDP figures explain in part why so many people are feeling squeezed despite our supposedly booming economy.

But since our fiat dollar system is not going away anytime soon, it would benefit Congress and the American people to bring more transparency to how and why Fed monetary policy functions.

For starters, the Federal Reserve should:

Begin publishing the M3 statistics again. Let us see the numbers that most accurately reveal how much new money the Fed is pumping into the world economy. Tell us exactly what the President's Working Group on Financial Markets does and why. Explain how interest rates are set. Conservatives profess to support free markets, without wage and price controls. Yet the most important price of all, the price of money as determined by interest rates, is set arbitrarily in secret by the Fed rather than by markets! Why is this policy written in stone? Why is there no congressional input at least? Change legal tender laws to allow constitutional legal tender (commodity money) to compete domestically with the dollar.How can a policy of steadily debasing our currency be defended morally, knowing what harm it causes to those who still believe in saving money and assuming responsibility for themselves in their retirement years? Is it any wonder we are a nation of debtors rather than savers?

We need more transparency in how the Federal Reserve carries out monetary policy, and we need it soon.

April 18 (Bloomberg) -- People who were in diapers in the 1970s glibly talk about stagflation as if it were the coexistence of 2.5 percent real growth and 2.5 percent inflation. It's not.

Stagflation refers to the persistence of below trend growth (high unemployment) and stubbornly high inflation. The term was probably used first by a British member of Parliament, Ian MacLeod, in a 1965 speech to the House of Commons.

``We now have the worst of both worlds -- not just inflation on the one side or stagnation on the other. We have a sort of `stagflation' situation,'' the Tory MP said.

The disease wasn't confined to the U.K. It traveled swiftly and aggressively across the pond, taking root in the U.S. in the 1970s. The combination of loose monetary policy, two oil supply shocks, one in 1973 and the other in 1979, an over-regulated economy and a downshift in trend productivity growth conspired to deliver a decade of sluggish growth and high unemployment, a state of affairs that was previously thought to violate a basic law of nature.

Notice that I didn't include increased spending for the Vietnam War as a ``cause'' of higher inflation. It is always and everywhere the province of the central bank to monetize any spending, the government's or the private sector's, by printing enough money to pay for it in depreciated dollars.

When global stock markets went into one of their periodic swan dives last May, market reporters were at a loss to explain why. The ``S'' word made its first appearance of the cycle, went into remission and came back just in time for the Labor Department to report a 0.6 percent jump in the consumer price index for March, the biggest monthly increase in almost a year.

Expectations Shift

Outside of food and energy, the inflation news was unexpectedly good. The core CPI rose 0.1 percent in March and 2.5 percent in the last 12 months, down from a peak of 2.9 percent in September. The trend looks decidedly down, albeit in fits and starts.

So much so that ardent inflation hawk Stephen Cecchetti, professor of global finance at Brandeis University in Waltham, Massachusetts, and a former research director at the Federal Reserve Bank of New York, was inspired to publish a mea culpa in his monthly inflation missive.

``Well, I guess I could have been more wrong, but I'm not sure how,'' Cecchetti writes. ``For some time, I've expected inflation to rise, and it has been stable. Now, there are increasing signs that the inflation trend is actually falling,'' with evidence accumulating that the trend may fall ``to something closer to 2 percent,'' the Fed's implicit ceiling.

Instead of expecting further rate increases, Cecchetti now envisions the funds rate ``slowly falling back to neutral'' once the decline in inflation has been assured.

Differentiation

One key piece of evidence is the performance of owners equivalent rent, which comprises 30 percent of the core CPI. This measure of the imputed rental value of a home, derived from a survey of rental units, tends to understate inflation at the lows and overstate it at the highs. The 3-month annualized change in OER has come down from a peak of 4.9 percent last June to 3.1 percent in March.

So why the talk about stagflation?

Most economists, schooled in Keynesian theory, aren't very good at differentiating between the demand side and the supply side of the economy. They don't think it matters if prices rise because of a reduction in output or an increase in demand. No wonder they can't distinguish between that '70's economy and today's.

``Is it stagflation or is it just normal, late-cycle behavior of a lagging indicator?'' says Paul Kasriel, director of economic research at the Northern Trust Corp. in Chicago. ``In the stagflation of the '70s, energy prices were rising because of absolute declines in oil production. There was a wage-price spiral because of strong unions. Neither of these holds today.''

Laggards

Inflation has the distinction of being a lagging economic indicator. The change in the CPI for services is one of seven components of the Index of Lagging Economic Indicators. A second laggard is the change in labor cost per unit of output, or ``wage inflation,'' another faux concept. (Wages are the price of labor. Inflation is a general rise in the price level.)

What that means is that over time, these indicators have proved to turn up after the business cycle trough and down after the peak.

``Inflation typically lags growth by about a year, so the slowdown in growth since the spring of last year has only just started to depress core CPI,'' says Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, New York. ``The process has much further to run.''

Not Greenspan's Fed

The Federal Reserve is focused on inflation expectations, both as a vote of confidence in its credibility and as an independent determinant of inflation. Policy makers seem to have realized that talking more equates to expecting less.

In other words, the more Fed officials express their inflation concerns and downplay the notion that weak growth could motivate them to lower the benchmark overnight rate, the more restrained are market-based inflation expectations.

This is not the Greenspan Fed, where the slightest tremor in financial markets and hint of investor distress prompted the former Fed chairman to push the panic-ease button. As I wrote last February, when Ben Bernanke stepped into those oh-so-large Greenspan shoes, ``The Greenspan `put' may retire with the chairman.''

It may mean investors have to buy puts of their own as insurance against the slowdown in economic growth.

Without shying away from controversy, we do away with a number of myths of why the US dollar ought to move up or down.

Myth I: The dollar is safe because the US has ample assetsSome say the US current-account deficit that requires foreigners to arrange for more than $3 billion of capital inflows every business day just to keep the dollar from falling does not matter. These pundits say a deficit of 6.5% of gross domestic product

(GDP) is sustainable because the deficit is only about 1% of all private assets held in the United States; as a result, deficits could be carried a long, long time.

This argument is one about the dollar going to zero, an extreme case of the dollar losing relative to other currencies. However, the current-account deficit and its affect on the dollar are about cash flow: putting it in the context of GDP is reasonable, as GDP is a cash-flow measure of production. Comparing it to private savings is mixing apples with oranges.

Myth II: The dollar is doomed because of the large US budget deficit Just as dollar optimists are wrong to say the dollar is safe because of the United States' tremendous wealth, dollar pessimists are mistaken by putting too much emphasis on the budget deficit. By issuing debt, the direct impact of the budget deficit can be mitigated to the burden of interest payments. Of course, as interest payments become excessively large, they will weigh on the dollar eventually. However, the linkage to the dollar is indirect. While it is correct that large budget deficits structurally weaken the US in the long run, it is not appropriate to link short-term dollar movements to the budget deficit.

Myth III: A lower dollar will cure the trade deficit All too often we hear how much more competitive the US would be if it only allowed the dollar to fall. While a weaker dollar may be a short-term boost to earnings and make exports a tad more competitive, it will not bring back industries that have been outsourced. It is most unlikely that the US will thrive on exporting shoes to China, no matter how low the dollar will fall.

What a weaker dollar may do is provide temporary relief. But unless the US turns into a society of savers and investors, a weaker dollar will only be a pause to an even weaker dollar as imbalances are built up yet again.

Myth IV: A lower trade deficit will save the dollar Odds are that the current-account deficit may be close to its peak. However, that does not mean the dollar is out of the woods: if an abatement in the rate at which the current-account deficit deepens were due to a sustained improvement in savings and investments, it might have long-term positive implications for the dollar.

But it looks as if the driver behind any "improvement" (if one can talk of such as the deficit continues to widen) will be due to a drop in domestic consumption due to a slowing economy. Rather than being good news for the dollar, this discourages foreign investors to invest in the US. American chief executive officers focus their investments abroad, so why should foreigners invest in the US?

As the US economy slows and consumers can no longer extract equity from their homes, the savings rate ought to go up. Famous for having dipped into negative territory, consumers have to pare back their spending as access to easy money dries up.

Myth V: A weak economy causes a currency to falterWe agree that the US economy is heavily dependent on growth to keep the dollar stable. But it is a US-specific problem: in the current environment, it may not apply to the European Union. The key difference is that, in recent years, the EU has focused on structural reform rather than growth; as a result, it does not have the severe current-account deficit the US has. Should the world economy slow down, many markets may suffer, but the euro might still do comparatively well. Europe has plenty of issues, but as far as the euro is concerned, the region is in a very strong position.

In contrast, a reduction of foreign-money inflows into the US is the single biggest threat to the greenback. As a result, the dollar has been reacting negatively to any news signaling a slowdown of US consumer spending. And as consumer spending is closely linked to the fate of the housing market, negative data on housing may reflect negatively on the dollar. As the housing market is not very liquid, any adjustment process is likely to be long and grinding.

Myth VI: China is the problemIn our assessment, China is the most responsible player in Asia. We believe other Asian countries, including Japan, are willing to risk a destruction of their currencies to continue to export to American consumers. The Chinese are taking their imbalances very seriously and are working hard at addressing many issues facing a nation governing 1.4 billion people. Having invited Western investment banks to invest billions in their local banks has provided an encouragement for reform from within.

If there is one thing that spooks the currency markets more than a slowdown in US real estate, it is the flaring-up of a protectionist-talking US Congress. When presidential candidate Hillary Clinton recently expressed concern about the Chinese buying up the majority of US debt, the dollar fell sharply. If protectionist measures increase, foreigners will have fewer incentives to purchase dollar-denominated assets, providing pressure on both the dollar and interest rates.

Interestingly, nobody seems to focus on the fact that there is an unconventional solution to foreigners holding too much of America's debt: live within your means and do not issue debt. Such an old-fashioned concept would indeed strengthen the dollar. Unfortunately, none of the presidential candidates at either side of the aisle seem to have heard of this notion.

Myth VII: Higher interest rates help the dollar It seems that ever since academics developed a theory of how interest-rate differentials move currencies, the theory has not worked. Yet just about every textbook continues to teach it. Aside from the fact that expectations on future interest rates and inflation are more relevant than actual interest rates, there are simply too many factors influencing currencies to be able to focus on interest rates. Why do some low-yielding currencies, such as the Swiss franc, perform reasonably well, whereas many developing countries have weak currencies despite high interest rates?

A good year ago, the US joined the ranks of developing nations in paying more in interest to overseas creditors than it receives in interest from its own investments. As a result, higher US interest rates mean higher payments abroad, further weakening the foundations of the US dollar.

There are many more myths about the dollar, but the selection above may provide some food for thought.

Summary: Global financial instability has sparked a surge in "monetary nationalism" -- the idea that countries must make and control their own currencies. But globalization and monetary nationalism are a dangerous combination, a cause of financial crises and geopolitical tension. The world needs to abandon unwanted currencies, replacing them with dollars, euros, and multinational currencies as yet unborn.

THE RISE OF MONETARY NATIONALISM

Capital flows have become globalization's Achilles' heel. Over the past 25 years, devastating currency crises have hit countries across Latin America and Asia , as well as countries just beyond the borders of western Europe -- most notably Russia and Turkey. Even such an impeccably credentialed pro-globalization economist as U.S. Federal Reserve Governor Frederic Mishkin has acknowledged that "opening up the financial system to foreign capital flows has led to some disastrous financial crises causing great pain, suffering, and even violence."

The economics profession has failed to offer anything resembling a coherent and compelling response to currency crises. International Monetary Fund (IMF) analysts have, over the past two decades, endorsed a wide variety of national exchange-rate and monetary policy regimes that have subsequently collapsed in failure. They have fingered numerous culprits, from loose fiscal policy and poor bank regulation to bad industrial policy and official corruption. The financial-crisis literature has yielded policy recommendations so exquisitely hedged and widely contradicted as to be practically useless.

Antiglobalization economists have turned the problem on its head by absolving governments (except the one in Washington) and instead blaming crises on markets and their institutional supporters, such as the IMF -- "dictatorships of international finance," in the words of the Nobel laureate Joseph Stiglitz. "Countries are effectively told that if they don't follow certain conditions, the capital markets or the IMF will refuse to lend them money," writes Stiglitz. "They are basically forced to give up part of their sovereignty."

Is this right? Are markets failing, and will restoring lost sovereignty to governments put an end to financial instability? This is a dangerous misdiagnosis. In fact, capital flows became destabilizing only after countries began asserting "sovereignty" over money -- detaching it from gold or anything else considered real wealth. Moreover, even if the march of globalization is not inevitable, the world economy and the international financial system have evolved in such a way that there is no longer a viable model for economic development outside of them.

The right course is not to return to a mythical past of monetary sovereignty, with governments controlling local interest and exchange rates in blissful ignorance of the rest of the world. Governments must let go of the fatal notion that nationhood requires them to make and control the money used in their territory. National currencies and global markets simply do not mix; together they make a deadly brew of currency crises and geopolitical tension and create ready pretexts for damaging protectionism. In order to globalize safely, countries should abandon monetary nationalism and abolish unwanted currencies, the source of much of today's instability.

THE GOLDEN AGE

Capital flows were enormous, even by contemporary standards, during the last great period of "globalization," from the late nineteenth century to the outbreak of World War I. Currency crises occurred during this period, but they were generally shallow and short-lived. That is because money was then -- as it has been throughout most of the world and most of human history -- gold, or at least a credible claim on gold. Funds flowed quickly back to crisis countries because of confidence that the gold link would be restored. At the time, monetary nationalism was considered a sign of backwardness, adherence to a universally acknowledged standard of value a mark of civilization. Those nations that adhered most reliably (such as Australia, Canada , and the United States) were rewarded with the lowest international borrowing rates. Those that adhered the least (such as Argentina, Brazil , and Chile) were punished with the highest.

This bond was fatally severed during the period between World War I and World War II. Most economists in the 1930s and 1940s considered it obvious that capital flows would become destabilizing with the end of reliably fixed exchange rates. Friedrich Hayek noted in a 1937 lecture that under a credible gold-standard regime, "short-term capital movements will on the whole tend to relieve the strain set up by the original cause of a temporarily adverse balance of payments. If exchanges, however, are variable, the capital movements will tend to work in the same direction as the original cause and thereby to intensify it" -- as they do today.

The belief that globalization required hard money, something foreigners would willingly hold, was widespread. The French economist Charles Rist observed that "while the theorizers are trying to persuade the public and the various governments that a minimum quantity of gold ... would suffice to maintain monetary confidence, and that anyhow paper currency, even fiat currency, would amply meet all needs, the public in all countries is busily hoarding all the national currencies which are supposed to be convertible into gold." This view was hardly limited to free marketeers. As notable a critic of the gold standard and global capitalism as Karl Polanyi took it as obvious that monetary nationalism was incompatible with globalization. Focusing on the United Kingdom's interest in growing world trade in the nineteenth century, he argued that "nothing else but commodity money could serve this end for the obvious reason that token money, whether bank or fiat, cannot circulate on foreign soil." Yet what Polanyi considered nonsensical -- global trade in goods, services, and capital intermediated by intrinsically worthless national paper (or "fiat") monies -- is exactly how globalization is advancing, ever so fitfully, today.

The political mythology associating the creation and control of money with national sovereignty finds its economic counterpart in the metamorphosis of the famous theory of "optimum currency areas" (OCA). Fathered in 1961 by Robert Mundell, a Nobel Prize-winning economist who has long been a prolific advocate of shrinking the number of national currencies, it became over the subsequent decades a quasi-scientific foundation for monetary nationalism.

Mundell, like most macroeconomists of the early 1960s, had a now largely discredited postwar Keynesian mindset that put great faith in the ability of policymakers to fine-tune national demand in the face of what economists call "shocks" to supply and demand. His seminal article, "A Theory of Optimum Currency Areas," asks the question, "What is the appropriate domain of the currency area?" "It might seem at first that the question is purely academic," he observes, "since it hardly appears within the realm of political feasibility that national currencies would ever be abandoned in favor of any other arrangement."

Mundell goes on to argue for flexible exchange rates between regions of the world, each with its own multinational currency, rather than between nations. The economics profession, however, latched on to Mundell's analysis of the merits of flexible exchange rates in dealing with economic shocks affecting different "regions or countries" differently; they saw it as a rationale for treating existing nations as natural currency areas. Monetary nationalism thereby acquired a rational scientific mooring. And from then on, much of the mainstream economics profession came to see deviations from "one nation, one currency" as misguided, at least in the absence of prior political integration.

The link between money and nationhood having been established by economists (much in the way that Aristotle and Jesus were reconciled by medieval scholastics), governments adopted OCA theory as the primary intellectual defense of monetary nationalism. Brazilian central bankers have even defended the country's monetary independence by publicly appealing to OCA theory -- against Mundell himself, who spoke out on the economic damage that sky-high interest rates (the result of maintaining unstable national monies that no one wants to hold) impose on Latin American countries. Indeed, much of Latin America has already experienced "spontaneous dollarization": despite restrictions in many countries, U.S. dollars represent over 50 percent of bank deposits. (In Uruguay, the figure is 90 percent, reflecting the appeal of Uruguay's lack of currency restrictions and its famed bank secrecy.) This increasingly global phenomenon of people rejecting national monies as a store of wealth has no place in OCA theory.

NO TURNING BACK

Just a few decades ago, vital foreign investment in developing countries was driven by two main motivations: to extract raw materials for export and to gain access to local markets heavily protected against competition from imports. Attracting the first kind of investment was simple for countries endowed with the right natural resources. (Companies readily went into war zones to extract oil, for example.) Governments pulled in the second kind of investment by erecting tariff and other barriers to competition so as to compensate foreigners for an otherwise unappealing business climate. Foreign investors brought money and know-how in return for monopolies in the domestic market.

This cozy scenario was undermined by the advent of globalization. Trade liberalization has opened up most developing countries to imports (in return for export access to developed countries), and huge declines in the costs of communication and transport have revolutionized the economics of global production and distribution. Accordingly, the reasons for foreign companies to invest in developing countries have changed. The desire to extract commodities remains, but companies generally no longer need to invest for the sake of gaining access to domestic markets. It is generally not necessary today to produce in a country in order to sell in it (except in large economies such as Brazil and China ).

At the same time, globalization has produced a compelling new reason to invest in developing countries: to take advantage of lower production costs by integrating local facilities into global chains of production and distribution. Now that markets are global rather than local, countries compete with others for investment, and the factors defining an attractive investment climate have changed dramatically. Countries can no longer attract investors by protecting them against competition; now, since protection increases the prices of goods that foreign investors need as production inputs, it actually reduces global competitiveness.

In a globalizing economy, monetary stability and access to sophisticated financial services are essential components of an attractive local investment climate. And in this regard, developing countries are especially poorly positioned.

Traditionally, governments in the developing world exercised strict control over interest rates, loan maturities, and even the beneficiaries of credit -- all of which required severing financial and monetary links with the rest of the world and tightly controlling international capital flows. As a result, such flows occurred mainly to settle trade imbalances or fund direct investments, and local financial systems remained weak and underdeveloped. But growth today depends more and more on investment decisions funded and funneled through the global financial system. (Borrowing in low-cost yen to finance investments in Europe while hedging against the yen's rise on a U.S. futures exchange is no longer exotic.) Thus, unrestricted and efficient access to this global system -- rather than the ability of governments to manipulate parochial monetary policies -- has become essential for future economic development.

But because foreigners are often unwilling to hold the currencies of developing countries, those countries' local financial systems end up being largely isolated from the global system. Their interest rates tend to be much higher than those in the international markets and their lending operations extremely short -- not longer than a few months in most cases. As a result, many developing countries are dependent on U.S. dollars for long-term credit. This is what makes capital flows, however necessary, dangerous: in a developing country, both locals and foreigners will sell off the local currency en masse at the earliest whiff of devaluation, since devaluation makes it more difficult for the country to pay its foreign debts -- hence the dangerous instability of today's international financial system.

Although OCA theory accounts for none of these problems, they are grave obstacles to development in the context of advancing globalization. Monetary nationalism in developing countries operates against the grain of the process -- and thus makes future financial problems even more likely.

MONEY IN CRISIS

Why has the problem of serial currency crises become so severe in recent decades? It is only since 1971, when President Richard Nixon formally untethered the dollar from gold, that monies flowing around the globe have ceased to be claims on anything real. All the world's currencies are now pure manifestations of sovereignty conjured by governments. And the vast majority of such monies are unwanted: people are unwilling to hold them as wealth, something that will buy in the future at least what it did in the past. Governments can force their citizens to hold national money by requiring its use in transactions with the state, but foreigners, who are not thus compelled, will choose not to do so. And in a world in which people will only willingly hold dollars (and a handful of other currencies) in lieu of gold money, the mythology tying money to sovereignty is a costly and sometimes dangerous one. Monetary nationalism is simply incompatible with globalization. It has always been, even if this has only become apparent since the 1970s, when all the world's governments rendered their currencies intrinsically worthless.

Yet, perversely as a matter of both monetary logic and history, the most notable economist critical of globalization, Stiglitz, has argued passionately for monetary nationalism as the remedy for the economic chaos caused by currency crises. When millions of people, locals and foreigners, are selling a national currency for fear of an impending default, the Stiglitz solution is for the issuing government to simply decouple from the world: drop interest rates, devalue, close off financial flows, and stiff the lenders. It is precisely this thinking, a throwback to the isolationism of the 1930s, that is at the root of the cycle of crisis that has infected modern globalization.

Argentina has become the poster child for monetary nationalists -- those who believe that every country should have its own paper currency and not waste resources hoarding gold or hard-currency reserves. Monetary nationalists advocate capital controls to avoid entanglement with foreign creditors. But they cannot stop there. As Hayek emphasized in his 1937 lecture, "exchange control designed to prevent effectively the outflow of capital would really have to involve a complete control of foreign trade," since capital movements are triggered by changes in the terms of credit on exports and imports.

Indeed, this is precisely the path that Argentina has followed since 2002, when the government abandoned its currency board, which tried to fix the peso to the dollar without the dollars necessary to do so. Since writing off $80 billion worth of its debts (75 percent in nominal terms), the Argentine government has been resorting to ever more intrusive means in order to prevent its citizens from protecting what remains of their savings and buying from or selling to foreigners. The country has gone straight back to the statist model of economic control that has failed Latin America repeatedly over generations. The government has steadily piled on more and more onerous capital and domestic price controls, export taxes, export bans, and limits on citizens' access to foreign currency. Annual inflation has nevertheless risen to about 20 percent, prompting the government to make ham-fisted efforts to manipulate the official price data. The economy has become ominously dependent on soybean production, which surged in the wake of price controls and export bans on cattle, taking the country back to the pre-globalization model of reliance on a single commodity export for hard-currency earnings. Despite many years of robust postcrisis economic recovery, GDP is still, in constant U.S. dollars, 26 percent below its peak in 1998, and the country's long-term economic future looks as fragile as ever.

When currency crises hit, countries need dollars to pay off creditors. That is when their governments turn to the IMF, the most demonized institutional face of globalization. The IMF has been attacked by Stiglitz and others for violating "sovereign rights" in imposing conditions in return for loans. Yet the sort of compromises on policy autonomy that sovereign borrowers strike today with the IMF were in the past struck directly with foreign governments. And in the nineteenth century, these compromises cut far more deeply into national autonomy.

Historically, throughout the Balkans and Latin America , sovereign borrowers subjected themselves to considerable foreign control, at times enduring what were considered to be egregious blows to independence. Following its recognition as a state in 1832, Greece spent the rest of the century under varying degrees of foreign creditor control; on the heels of a default on its 1832 obligations, the country had its entire finances placed under French administration. In order to return to the international markets after 1878, the country had to precommit specific revenues from customs and state monopolies to debt repayment. An 1887 loan gave its creditors the power to create a company that would supervise the revenues committed to repayment. After a disastrous war with Turkey over Crete in 1897, Greece was obliged to accept a control commission, comprised entirely of representatives of the major powers, that had absolute power over the sources of revenue necessary to fund its war debt. Greece's experience was mirrored in Bulgaria, Serbia, the Ottoman Empire, Egypt, and, of course, Argentina .

There is, in short, no age of monetary sovereignty to return to. Countries have always borrowed, and when offered the choice between paying high interest rates to compensate for default risk (which was typical during the Renaissance) and paying lower interest rates in return for sacrificing some autonomy over their ability to default (which was typical in the nineteenth century), they have commonly chosen the latter. As for the notion that the IMF today possesses some extraordinary power over the exchange-rate policies of borrowing countries, this, too, is historically inaccurate. Adherence to the nineteenth-century gold standard, with the Bank of England at the helm of the system, severely restricted national monetary autonomy, yet governments voluntarily subjected themselves to it precisely because it meant cheaper capital and greater trade opportunities.

THE MIGHTY DOLLAR?

For a large, diversified economy like that of the United States , fluctuating exchange rates are the economic equivalent of a minor toothache. They require fillings from time to time -- in the form of corporate financial hedging and active global supply management -- but never any major surgery. There are two reasons for this. First, much of what Americans buy from abroad can, when import prices rise, quickly and cheaply be replaced by domestic production, and much of what they sell abroad can, when export prices fall, be diverted to the domestic market. Second, foreigners are happy to hold U.S. dollars as wealth.

This is not so for smaller and less advanced economies. They depend on imports for growth, and often for sheer survival, yet cannot pay for them without dollars. What can they do? Reclaim the sovereignty they have allegedly lost to the IMF and international markets by replacing the unwanted national currency with dollars (as Ecuador and El Salvador did half a decade ago) or euros (as Bosnia, Kosovo, and Montenegro did) and thereby end currency crises for good. Ecuador is the shining example of the benefits of dollarization: a country in constant political turmoil has been a bastion of economic stability, with steady, robust economic growth and the lowest inflation rate in Latin America. No wonder its new leftist president, Rafael Correa, was obliged to ditch his de-dollarization campaign in order to win over the electorate. Contrast Ecuador with the Dominican Republic , which suffered a devastating currency crisis in 2004 -- a needless crisis, as 85 percent of its trade is conducted with the United States (a figure comparable to the percentage of a typical U.S. state's trade with other U.S. states).

It is often argued that dollarization is only feasible for small countries. No doubt, smallness makes for a simpler transition. But even Brazil's economy is less than half the size of California's, and the U.S. Federal Reserve could accommodate the increased demand for dollars painlessly (and profitably) without in any way sacrificing its commitment to U.S. domestic price stability. An enlightened U.S. government would actually make it politically easier and less costly for more countries to adopt the dollar by rebating the seigniorage profits it earns when people hold more dollars. (To get dollars, dollarizing countries give the Federal Reserve interest-bearing assets, such as Treasury bonds, which the United States would otherwise have to pay interest on.) The International Monetary Stability Act of 2000 would have made such rebates official U.S. policy, but the legislation died in Congress, unsupported by a Clinton administration that feared it would look like a new foreign-aid program.

Polanyi was wrong when he claimed that because people would never accept foreign fiat money, fiat money could never support foreign trade. The dollar has emerged as just such a global money. This phenomenon was actually foreseen by the brilliant German philosopher and sociologist Georg Simmel in 1900. He surmised:

"Expanding economic relations eventually produce in the enlarged, and finally international, circle the same features that originally characterized only closed groups; economic and legal conditions overcome the spatial separation more and more, and they come to operate just as reliably, precisely and predictably over a great distance as they did previously in local communities. To the extent that this happens, the pledge, that is the intrinsic value of the money, can be reduced. ... Even though we are still far from having a close and reliable relationship within or between nations, the trend is undoubtedly in that direction."

But the dollar's privileged status as today's global money is not heaven-bestowed. The dollar is ultimately just another money supported only by faith that others will willingly accept it in the future in return for the same sort of valuable things it bought in the past. This puts a great burden on the institutions of the U.S. government to validate that faith. And those institutions, unfortunately, are failing to shoulder that burden. Reckless U.S. fiscal policy is undermining the dollar's position even as the currency's role as a global money is expanding.

Four decades ago, the renowned French economist Jacques Rueff, writing just a few years before the collapse of the Bretton Woods dollar-based gold-exchange standard, argued that the system "attains such a degree of absurdity that no human brain having the power to reason can defend it." The precariousness of the dollar's position today is similar. The United States can run a chronic balance-of-payments deficit and never feel the effects. Dollars sent abroad immediately come home in the form of loans, as dollars are of no use abroad. "If I had an agreement with my tailor that whatever money I pay him he returns to me the very same day as a loan," Rueff explained by way of analogy, "I would have no objection at all to ordering more suits from him."

With the U.S. current account deficit running at an enormous 6.6 percent of GDP (about $2 billion a day must be imported to sustain it), the United States is in the fortunate position of the suit buyer with a Chinese tailor who instantaneously returns his payments in the form of loans -- generally, in the U.S. case, as purchases of U.S. Treasury bonds. The current account deficit is partially fueled by the budget deficit (a dollar more of the latter yields about 20-50 cents more of the former), which will soar in the next decade in the absence of reforms to curtail federal "entitlement" spending on medical care and retirement benefits for a longer-living population. The United States -- and, indeed, its Chinese tailor -- must therefore be concerned with the sustainability of what Rueff called an "absurdity." In the absence of long-term fiscal prudence, the United States risks undermining the faith foreigners have placed in its management of the dollar -- that is, their belief that the U.S. government can continue to sustain low inflation without having to resort to growth-crushing interest-rate hikes as a means of ensuring continued high capital inflows.

PRIVATIZING MONEY

It is widely assumed that the natural alternative to the dollar as a global currency is the euro. Faith in the euro's endurance, however, is still fragile -- undermined by the same fiscal concerns that afflict the dollar but with the added angst stemming from concerns about the temptations faced by Italy and others to return to monetary nationalism. But there is another alternative, the world's most enduring form of money: gold.

It must be stressed that a well-managed fiat money system has considerable advantages over a commodity-based one, not least of which that it does not waste valuable resources. There is little to commend in digging up gold in South Africa just to bury it again in Fort Knox. The question is how long such a well-managed fiat system can endure in the United States. The historical record of national monies, going back over 2,500 years, is by and large awful.

At the turn of the twentieth century -- the height of the gold standard -- Simmel commented, "Although money with no intrinsic value would be the best means of exchange in an ideal social order, until that point is reached the most satisfactory form of money may be that which is bound to a material substance." Today, with money no longer bound to any material substance, it is worth asking whether the world even approximates the "ideal social order" that could sustain a fiat dollar as the foundation of the global financial system. There is no way effectively to insure against the unwinding of global imbalances should China, with over a trillion dollars of reserves, and other countries with dollar-rich central banks come to fear the unbearable lightness of their holdings.

So what about gold? A revived gold standard is out of the question. In the nineteenth century, governments spent less than ten percent of national income in a given year. Today, they routinely spend half or more, and so they would never subordinate spending to the stringent requirements of sustaining a commodity-based monetary system. But private gold banks already exist, allowing account holders to make international payments in the form of shares in actual gold bars. Although clearly a niche business at present, gold banking has grown dramatically in recent years, in tandem with the dollar's decline. A new gold-based international monetary system surely sounds far-fetched. But so, in 1900, did a monetary system without gold. Modern technology makes a revival of gold money, through private gold banks, possible even without government support.

COMMON CURRENCIES

Virtually every major argument recently leveled against globalization has been leveled against markets generally (and, in turn, debunked) for hundreds of years. But the argument against capital flows in a world with 150 fluctuating national fiat monies is fundamentally different. It is highly compelling -- so much so that even globalization's staunchest supporters treat capital flows as an exception, a matter to be intellectually quarantined until effective crisis inoculations can be developed. But the notion that capital flows are inherently destabilizing is logically and historically false. The lessons of gold-based globalization in the nineteenth century simply must be relearned. Just as the prodigious daily capital flows between New York and California, two of the world's 12 largest economies, are so uneventful that no one even notices them, capital flows between countries sharing a single currency, such as the dollar or the euro, attract not the slightest attention from even the most passionate antiglobalization activists.

Countries whose currencies remain unwanted by foreigners will continue to experiment with crisis-prevention policies, imposing capital controls and building up war chests of dollar reserves. Few will repeat Argentina's misguided efforts to fix a dollar exchange rate without the dollars to do so. If these policies keep the IMF bored for a few more years, they will be for the good.

But the world can do better. Since economic development outside the process of globalization is no longer possible, countries should abandon monetary nationalism. Governments should replace national currencies with the dollar or the euro or, in the case of Asia, collaborate to produce a new multinational currency over a comparably large and economically diversified area.

Europeans used to say that being a country required having a national airline, a stock exchange, and a currency. Today, no European country is any worse off without them. Even grumpy Italy has benefited enormously from the lower interest rates and permanent end to lira speculation that accompanied its adoption of the euro. A future pan-Asian currency, managed according to the same principle of targeting low and stable inflation, would represent the most promising way for China to fully liberalize its financial and capital markets without fear of damaging renminbi speculation (the Chinese economy is only the size of California's and Florida's combined). Most of the world's smaller and poorer countries would clearly be best off unilaterally adopting the dollar or the euro, which would enable their safe and rapid integration into global financial markets. Latin American countries should dollarize; eastern European countries and Turkey, euroize. Broadly speaking, this prescription follows from relative trade flows, but there are exceptions; Argentina, for example, does more eurozone than U.S. trade, but Argentines think and save in dollars.

Of course, dollarizing countries must give up independent monetary policy as a tool of government macroeconomic management. But since the Holy Grail of monetary policy is to get interest rates down to the lowest level consistent with low and stable inflation, an argument against dollarization on this ground is, for most of the world, frivolous. How many Latin American countries can cut interest rates below those in the United States? The average inflation-adjusted lending rate in Latin America is about 20 percent. One must therefore ask what possible boon to the national economy developing-country central banks can hope to achieve from the ability to guide nominal local rates up and down on a discretionary basis. It is like choosing a Hyundai with manual transmission over a Lexus with automatic: the former gives the driver more control but at the cost of inferior performance under any condition.

As for the United States , it needs to perpetuate the sound money policies of former Federal Reserve Chairs Paul Volcker and Alan Greenspan and return to long-term fiscal discipline. This is the only sure way to keep the United States' foreign tailors, with their massive and growing holdings of dollar debt, feeling wealthy and secure. It is the market that made the dollar into global money -- and what the market giveth, the market can taketh away. If the tailors balk and the dollar fails, the market may privatize money on its own.

Benn Steil is Director of International Economics at the Council on Foreign Relations and a co-author of Financial Statecraft.

Couldn't come up with a better place to file this. Think the map is interesting; with all the hue and cry over global warming, many are still hoofing it out of the north to the sunbelt. Voting against scare tactics with their feet?

Tuesday, December 23, 2008

More are saying so long to Michigan

State in danger of losing a congressional district after '10 count as population dips 46,000.

Mike Wilkinson / The Detroit News

Michigan's population loss accelerated this year, driven by an auto industry on the verge of collapse that has sent tens of thousands looking for a soft landing elsewhere in the country.The state lost an estimated 46,000 people between 2007 and 2008, and experts expect the state's population to fall below 10 million by next year.

Michigan's stagnant growth portends the loss of clout: With other parts of the country continuing to see robust growth, the state will likely lose one of its 15 Congressional districts after the 2010 census. If it does, it will mark the fourth consecutive decade that the state has lost a seat.

The state's decline is rooted in mobility: The rising number of people who are leaving the state far exceeds the number coming into it. The state had a net loss of 109,257 people to domestic migration, up from 95,787 a year earlier and 57,257 in 2005. Immigration from abroad, once able to balance the domestic losses, continued to decline as well, with just 16,627 coming to Michigan, down from its recent high of 23,328 in 2001.

"It's that out-migration. It keeps going -- more and more and more," said Kurt Metzger, director of the Detroit Area Community Indicators System, a local nonprofit. "There's nothing else."Births rose and deaths declined for the third consecutive year, pushing the state's "natural increase" up. But it was the loss from movers, many of whom left for economic reasons, which drove the state's population downward.

"When opportunities present themselves, people will move," said Rick Waclawek, director of the Michigan Department of Labor and Growth's Bureau of Labor Market Information and Strategic Initiatives.

Waclawek is hopeful that the Obama administration's economic stimulus plan -- estimated to pump from $650 billion to $850 billion into the economy -- will stem the tide of losses. Projects that may be undertaken with federal money could attract some of the same people who have left, he said.

The stimulus money is expected to go toward a range of initiatives, from tax relief and money for state governments to infrastructure projects."It's a dynamic society we're living in," he said.

Michael Duffield has been in real estate for 15 years and he's seeing some strange things in the market: People swapping houses, people walking away from their homes. Many are choosing the devastation of foreclosure and a move to another state for a job over sticking it out in Michigan.

"They're saying, 'Life marches on. I won't be a homeowner, I'll be a home renter,' " Duffield said.

Whether the movement out of the state will increase is unknown. With much of the rest of the country now experiencing the recession Michigan has dealt with for the better part of eight years, opportunities elsewhere have shrunk.

"They can't go many other places anymore," said Xuan Liu, manager of the data center for the Southeast Michigan Council of Governments.

Overall, Michigan lost nearly 0.5 percent of its population in the last year; Rhode Island lost 0.2 percent. All other states showed an increase, with Utah, Arizona, Texas, North Carolina and Colorado showing the biggest percentage increases. Texas added 483,542 residents, the largest increase in people.

Regionally, the Northeast had the slowest overall increase, at 0.3 percent and 163,000 people, followed by the Midwest at 0.4 percent, or 249,000 people. The South added nearly 1.4 million people, or 1.3 percent, while the West added 974,000, or 1.4 percent.

The population changes represent a steady shift over nearly a half-century. In 1960, the Midwest and Northeast comprised more than half the nation's population, with the West and South just under half. Now, the West and South make up 60 percent of the population; the Midwest and Northeast just 40 percent.

Likewise, the loss of political clout has been steady: Michigan had as many as 19 seats in the U.S. House of Representatives as late as 1982. But it lost one seat in advance of that's year's election; two in the 1990s, and one following the 2000 census. Meanwhile, the South and West have gained dozens and could add another eight after the 2010 count.

The Census Bureau uses birth and death records, as well as income tax returns to gauge population trends. The estimates, however, do not affect a state's federal funding, which is based instead on the decennial census counts.

With the auto industry, like most of the economy, mired in doubt, it's unclear when Michigan will pull out of its current downspin, the worst since the state saw a larger decline in population from 1981 to 1983. Economists are saying it will be late 2009 if not 2010 before the state sees a recovery.

I've bumped into this argument in a couple of places now and it's piqued my interest. I'd be interested in hearing what you all think.

A Book that Changes EverythingDaily Article by Jeffrey A. Tucker | Posted on 1/16/2009 12:00:00 AM

At a taped video interview in my office, before the crew would start the camera, a man had to remove my Picasso prints from the wall. The prints are probably under copyright, they said.

But the guy who drew them died 30 years ago. Besides, they are mine.

Doesn't matter. They have to go.

What about the poor fellow who painted the wall behind the prints? Why doesn't he have a copyright? If I scrape off the paint, there is the drywall and its creator. Behind the drywall are the boards, which are surely proprietary too. To avoid the "intellectual-property" thicket, maybe we have to sit in an open field; but there is the problem of the guy who last mowed the grass. Then there is the inventor of the grass to consider.

Is there something wrong with this picture?

The worldly-wise say no. This is just the way things are. It is for us not to question but to obey. So it is with all despotisms in human history. They become so woven into the fabric of daily life that absurdities are no longer questioned. Only a handful of daring people are capable of thinking along completely different lines. But when they do, the earth beneath our feet moves.

Such is the case with Against Intellectual Monopoly (Cambridge University Press, 2008) by Michele Boldrin and David Levine, two daring professors of economics at Washington University in St. Louis. They have written a book that is likely to rock your world, as it has mine. (It is also posted on their site with the permission on the publisher.)With piracy and struggles over intellectual property in the news daily, it is time to wonder about this issue, its relationship to freedom, property rights, and efficiency. You have to think seriously about where you stand.

This is not one of those no-brainer issues for libertarians, like minimum wage or price controls. The problem is complicated, and solving it requires careful thought. But it is essential that every person do the thinking, and there is no better tool for breaking the intellectual gridlock than this book.

The issue is impossible to escape, from the grave warnings you get from the FBI at the beginning of "your" DVD to the posters warning kids never to download a song to the outrageous settlements transferring billions from firm to firm. It even affects the outrageous prices you pay for medicine at the drug store. The issue of "intellectual property" is a ubiquitous part of modern life.

Some of the police-state tactics used to enforce IP have to make anyone with a conscience squeamish. You have surely wondered about the right and wrong of all this, but, if you are like most people, you figure that copyrights and patents are consistent with the justice that comes from giving the innovator his due. In principle they seem fine, even if the law might be in need of reform.

The first I'd ever thought critically about issues of intellectual property was in reading about it in the abstract many years ago. The Austrian position has traditionally favored copyrights on the same grounds it has favored property rights in general, but has tended to oppose patents on grounds that they are government grants of monopolistic privilege. Machlup, Mises, and Rothbard — as well as Stigler, Plant, and Penrose — have discussed the issue but not at great length and with varying levels of cautious skepticism.

That changed in 2001 with the publication of Stephan Kinsella's article and now monograph "Against Intellectual Property." He made a strongly theoretical argument that ideas are not scarce, do not require rationing, are not diminished by their dissemination, and so cannot really be called property. All IP is unjust, he wrote. It is inconsistent with libertarian ethics and contrary to a free market. He favors the complete repeal of all intellectual-property laws.

The argument initially struck me as crazy on its face. As I considered it further, my own view gradually changed: it's not crazy, I thought, but it is still pie-in-the-sky theorizing that has nothing to do with reality. Kinsella's article appeared just before the explosive public interest in this subject. The patent regime has in the meantime gone completely wild, with nearly 200,000 patents issued every year in the United States, and half a million more in other countries — with 6.1 million patents in effect worldwide — and large firms collecting stockpiles of them.

And the copyright issue has led to a massive struggle between generations: young people live by "pirating" music, movies, software, whereas the old consider this practice to presage the end of the capitalist system as we know it. The music industry has spent billions trying to contain the problem and only ended up engendering consumer embitterment and terrible public relations.

Kinsella's article continued to haunt me personally. It took about six years or so, but I finally worked through all the theoretical problems and came to embrace his view, so you might say that I was predisposed to hear what these authors have to say. What I hadn't realized until encountering the Boldrin/Levine book was just how far-reaching and radical the implications of a detailed look at IP really is.

It is not just a matter of deciding what you believe from a theoretical or political perspective. It is not just a matter of thinking that "pirates" are not really violating moral law. To fully absorb what these authors say changes the way you look at technology, at history, at the ebbs and flows of economic development, and even who the good guys and bad guys are in the history of civilization.

Kinsella deals expertly with the theoretical aspects, while Against Intellectual Monopoly doesn't really go into the theory at great length. What this amazing book deals with is the real-world practice of intellectual-property regulation now and in history. I can make a personal guarantee that not a single objection you think you have to their thesis goes unaddressed in these pages. Their case is like the sun that melts all snow for many miles in all directions.

The implications are utterly shattering, and every day I've turned the pages in the Boldrin/Levine book I've felt that sense of intellectual stimulation that comes along rarely in life — that sense that makes you want to grab anyone off the street and tell that person what this book says. It helps you understand many things that had previously been confusing. The emergent clarity that comes from having absorbed this work is akin to what it must feel like to hear or see for the first time. If they are right, the implications are astonishing.

Their main thesis is a seemingly simple one. Copyright and patents are not part of the natural competitive order. They are products of positive law and legislation, imposed at the behest of market winners as a means of excluding competition. They are government grants of monopolies, and, as neoclassical economists with a promarket disposition, the authors are against monopoly because it raises prices, generates economic stagnation, inhibits innovation, robs consumers, and rewards special interests.

What they have done is apply this conventional model of monopoly to one of the most long-lasting, old-world forms of mercantilist/monopolistic institutional privilege, a surviving form of mercantilist privilege of the 16th century. IP is like a dam in the river of development, or perhaps very large boulders that impede the flow.

They too favor its total repeal but their case goes far beyond the theoretical. They convince you that radical, far-reaching, uncompromising, revolutionary reform is essential to our social well-being now and in the future.

The results are dazzling and utterly persuasive. I personally dare anyone who thinks that he believes in patent or copyright to read this book and deal with it. For this reason, I'm thrilled that the Mises Institute is now carrying the book to give it the broadest possible exposure.

I'm not sure what aspect of their case is the most powerful. Here are just a few examples:

They show that people like James Watt, Eli Whitney, and the Wright Brothers are not heroes of innovation, as legend has it, but rent-seeking mercantilists who dramatically set back the cause of technological development. These people spent vast resources prohibiting third parties from improving "their" product and making it available at a cheaper price. Instead of promoting innovation and profitability, they actually stopped it, even at the cost of their own business dreams.

The authors show that every great period of innovation in human history has taken place in the absence of intellectual property, and that every thicket of IP has ended up stagnating the industries to which they apply. Think of the early years of the web, in which open-source technology inspired breakneck development, until patents and copyright were imposed with the resulting cartelization of operating systems. Even today, the greatest innovations in digital communications come from the highly profitable open-source movement.

It is impossible to develop software without running into IP problems, and the largest players are living off IP and not innovation. Meanwhile, the most profitable and most innovative sector of the web, the porn sector, has no access to courts and IP enforcement because of the stigma associated with it. It is not an accident that absence of IP coincides with growth and innovation. The connection is causal.

And look at the industries that do not have IP access, such as clothing design and architecture and perfume. They are huge and fast moving and fabulous. First movers still make the big bucks, without coercing competition. Boldrin and Levine further speculate that IP is behind one of the great puzzles of the last millennium: stagnation in classical music. The sector is seriously burdened and tethered by IP.

Other mysteries are answered. Why no musical composition of note in England after 1750? England had the world's most strict copyright laws. Why was English literature so popular in the United States in the 19th-century schoolrooms? It could be imported without copyright restriction — and therefore sold cheaply — whereas American authors used IP and limited their market. And consider the irony that Disney, which relies heavily on IP, got its start and makes it largest profits by retelling public-domain stories!

Examples like this abound. One wonders if the modern history of literature and art needs to be completely rewritten. Examples will occur to you that are not discussed in the book, such as fan fiction. It is technically illegal, so far as anyone can tell, to take a copyrighted character and tell a story about him even if the story is original. And yet Harry Potter fan-fiction sites enjoy tens of millions of hits per month. One hosts 5,000 pieces of fan fiction, some as long as 1,000 pages. Enforcement has been spotty and unpredictable.

And yes, the book covers the poster child of the IP world: pharmaceuticals. They muster plenty of evidence that IP here does nothing to promote innovation and widespread availability and is largely responsible for the egregiously high prices of drugs that are driving the system toward socialization.

The authors explore the very strange tendency of capitalists to misdiagnose the source of their profits in a world of IP, spending far more on beating up pirates than they would have earned in a free market. They further demonstrate that IP is a form of exploitation and expropriation that is gravely dangerous for civilization itself.

In short, they have taken what might seem to be merely a geeky concern and moved it to the center of discussion over economic development itself.

What about the far-flung conclusion that IP should be repealed? The authors take away your fears. The development of IP came about in the 16th century as a mechanism for governments to enforce political control and punish dissenters. The cause of this "property right" was then taken over by individuals in the 18th and 19th century as part of the liberal revolution for individual rights. In the 20th century, it was transferred again, to corporations who become the effective owners through copyright. The creators no longer own anything, and let themselves be beaten and abused by their own publishers and production companies.

Boldrin and Levine's thesis really steps up this issue. It makes you wonder how long authors and creators will put up with the nonsense that some company has a state-enforced exclusive to use the work of others for longer than 100 years. Fortunately, the digital age is forcing the issue, and alternatives like Creative Commons (roughly akin to what would exist in a free market) are becoming increasingly popular. As the tyranny has grown more obvious, the free market is responding.

No, the authors are not really Austrian, and I'm not even sure that they can be called libertarians, but they understand the competitive process in ways that would make Hayek and Mises proud. As I've thought more about their book, it seems that it might suggest a revision in classical-liberal theory. We have traditionally thought that cooperation and competition were the two pillars of social order; a third could be added: emulation. In addition, there is surely work to do here that integrates Hayek's theory of knowledge with the problem of IP.

If the book lacks for anything, it is precisely what Kinsella provides: a robust theory behind the practical analytics. But since Kinsella has already provided this, the value added of real-world application is enormous. I have a minor nit to pick with them on their passing comment on trademarks, which strikes me as wrong. Otherwise, this book moves mountains.

In the coming weeks I will blog about this book chapter by chapter, and Mises.org plans a series of excerpts from it. For now, let me say that a book like this comes along very rarely. Against Intellectual Monopoly is a relatively small manifesto on economics that absolutely must be understood and absorbed by every thinking person without exception.

Jeffrey Tucker is the editor of Mises.org. Send him mail. See his article archives.

A lot of compliments for the book from the author of this piece, but I would like to see more discussison of the actual issues. If the author of this piece blogs the book chapter by chapter and actually enters into discussion on the merits, that I would be curious to see.

In late 1764, while repairing a small Newcomen steam engine, the idea of allowing steam to expand and condense in separate containers sprang into the mind of James Watt. He spent the next few months in unceasing labor building a model of the new engine. In 1768, after a series of improvements and substantial borrowing, he applied for a patent on the idea, requiring him to travel to London in August. He spent the next six months working hard to obtain his patent. It was finally awarded in January of the following year. Nothing much happened by way of production until 1775. Then, with a major effort supported by his business partner, the rich industrialist Matthew Boulton, Watt secured an act of Parliament extending his patent until the year 1800. The great statesman Edmund Burke spoke eloquently in Parliament in the name of economic freedom and against the creation of unnecessary monopoly — but to no avail.[1] The connections of Watt's partner Boulton were too solid to be defeated by simple principle.

Once Watt's patents were secured and production started, a substantial portion of his energy was devoted to fending off rival inventors. In 1782, Watt secured an additional patent, made "necessary in consequence of ... having been so unfairly anticipated, by [Matthew] Wasborough in the crank motion" [2]. More dramatically, in the 1790s, when the superior Hornblower engine was put into production, Boulton and Watt went after him with the full force of the legal system.[3]

During the period of Watt's patents the United Kingdom added about 750 horsepower of steam engines per year. In the thirty years following Watt's patents, additional horsepower was added at a rate of more than 4,000 per year. Moreover, the fuel efficiency of steam engines changed little during the period of Watt's patent; while between 1810 and 1835 it is estimated to have increased by a factor of five.[4]

After the expiration of Watt's patents, not only was there an explosion in the production and efficiency of engines, but steam power came into its own as the driving force of the Industrial Revolution. Over a thirty year period steam engines were modified and improved as crucial innovations such as the steam train, the steamboat and the steam jenny came into wide usage. The key innovation was the high-pressure steam engine — development of which had been blocked by Watt's strategic use of his patent. Many new improvements to the steam engine, such as those of William Bull, Richard Trevithick, and Arthur Woolf, became available by 1804: although developed earlier these innovations were kept idle until the Boulton and Watt patent expired. None of these innovators wished to incur the same fate as Jonathan Hornblower.[5]

Ironically, not only did Watt use the patent system as a legal cudgel with which to smash competition, but his own efforts at developing a superior steam engine were hindered by the very same patent system he used to keep competitors at bay. An important limitation of the original Newcomen engine was its inability to deliver a steady rotary motion. The most convenient solution, involving the combined use of the crank and a flywheel, relied on a method patented by James Pickard, which prevented Watt from using it. Watt also made various attempts at efficiently transforming reciprocating into rotary motion, reaching, apparently, the same solution as Pickard. But the existence of a patent forced him to contrive an alternative less-efficient mechanical device, the "sun and planet" gear. It was only in 1794, after the expiration of Pickard's patent that Boulton and Watt adopted the economically and technically superior crank.[6]

The impact of the expiration of his patents on Watt's empire may come as a surprise. As might be expected, when the patents expired "many establishments for making steam-engines of Mr. Watt's principle were then commenced." However, Watt's competitors "principally aimed at...cheapness rather than excellence." As a result, we find that far from being driven out of business "Boulton and Watt for many years afterwards kept up their price and had increased orders" [7].

In fact, it is only after their patents expired that Boulton and Watt really started to manufacture steam engines. Before then their activity consisted primarily of extracting hefty monopolistic royalties through licensing. Independent contractors produced most of the parts, and Boulton and Watt merely oversaw the assembly of the components by the purchasers.

In most histories, James Watt is a heroic inventor, responsible for the beginning of the Industrial Revolution. The facts suggest an alternative interpretation. Watt is one of many clever inventors working to improve steam power in the second half of the eighteenth century. After getting one step ahead of the pack, he remained ahead not by superior innovation, but by superior exploitation of the legal system. The fact that his business partner was a wealthy man with strong connections in Parliament, was not a minor help.

Was Watt's patent a crucial incentive needed to trigger his inventive genius, as the traditional history suggests? Or did his use of the legal system to inhibit competition set back the industrial revolution by a decade or two? More broadly, are the two essential components of our current system of intellectual property — patents and copyrights — with all of their many faults, a necessary evil we must put up with to enjoy the fruits of invention and creativity? Or are they just unnecessary evils, the relics of an earlier time when governments routinely granted monopolies to favored courtiers? That is the question we seek to answer.

In the specific case of Watt, the granting of the 1769 and especially of the 1775 patents likely delayed the mass adoption of the steam engine: innovation was stifled until his patents expired; and few steam engines were built during the period of Watt's legal monopoly. From the number of innovations that occurred immediately after the expiration of the patent, it appears that Watt's competitors simply waited until then before releasing their own innovations. This should not surprise us: new steam engines, no matter how much better than Watt's, had to use the idea of a separate condenser. Because the 1775 patent provided Boulton and Watt with a monopoly over that idea, plentiful other improvements of great social and economic value could not be implemented. By the same token, until 1794 Boulton and Watt's engines were less efficient they could have been because the Pickard's patent prevented anyone else from using, and improving, the idea of combining a crank with a flywheel.

Also, we see that Watt's inventive skills were badly allocated: we find him spending more time engaged in legal action to establish and preserve his monopoly than he did in the actual improvement and production of his engine. From a strictly economic point of view Watt did not need such a long-lasting patent — it is estimated that by 1783 — seventeen years before his patent expired — his enterprise had already broken even. Indeed, even after their patent expired, Boulton and Watt were able to maintain a substantial premium over the market by virtue of having been first, despite the fact that their competitors had had thirty years to learn how to make steam engines.

The wasteful effort to suppress competition and obtain special privileges is referred to by economists as rent-seeking behavior. History and common sense show it to be a poisoned fruit of legal monopoly. Watt's attempt to extend the duration of his 1769 patent is an especially egregious example of rent seeking: the patent extension was clearly unnecessary to provide incentive for the original invention, which had already taken place. On top of this, we see Watt using patents as a tool to suppress innovation by his competitors, such as Hornblower, Wasborough and others. Hornblower's engine is a perfect case in point: it was a substantial improvement over Watt's as it introduced the new concept of the "compound engine" with more than one cylinder. This, and not the Boulton and Watt design, was the basis for further steam-engine development after their patents expired. However, because Hornblower built on the earlier work of Watt, making use of his "separate condenser" Boulton and Watt were able to block him in court and effectively put an end to steam-engine development. The monopoly over the "separate condenser," a useful innovation, blocked the development of another equally useful innovation, the "compound engine," thereby retarding economic growth. This retardation of innovation is a classical case of what we shall refer to as intellectual-property inefficiency, or IP inefficiency for short.

Finally, there is the slow rate at which the steam engine was adopted before the expiration of Watt's patent. By keeping prices high and preventing others from producing cheaper or better steam engines, Boulton and Watt hampered capital accumulation and slowed economic growth.

The story of James Watt is a damaging case for the benefits of a patent system, but we shall see that it is not an unusual story. A new idea accrues almost by chance to the innovator while he is carrying out a routine activity aimed at a completely different end. The patent comes many years after that and it is due more to a mixture of legal acumen and abundant resources available to "oil the gears of fortune" than anything else. Finally, after the patent protection is obtained, it is primarily used as a tool to prevent economic progress and hurt competitors.

$30 $27

While this view of Watt's role in the Industrial Revolution may appear iconoclastic, it is neither new nor particularly original. Frederic Scherer, a prestigious academic supporter of the patent system, after going through the details of the Boulton and Watt story, concluded his 1986 examination of their story with the following illuminating words:

Had there been no patent protection at all,…Boulton and Watt certainly would have been forced to follow a business policy quite different from that which they actually followed. Most of the firm's profits were derived from royalties on the use of engines rather than from the sale of manufactured engine components, and without patent protection the firm plainly could not have collected royalties. The alternative would have been to emphasize manufacturing and service activities as the principal source of profits, which in fact was the policy adopted when the expiration date of the patent for the separate condenser drew near in the late 1790s…. It is possible to conclude more definitely that the patent litigation activities of Boulton & Watt during the 1790s did not directly incite further technological progress…. Boulton and Watt's refusal to issue licenses allowing other engine makers to employ the separate-condenser principle clearly retarded the development and introduction of improvements.[8]Michele Boldrin teaches economics at Washington University in Saint Louis and is co-author of Against Intellectual Monopoly. See his website. Send him mail. See his article archives. You can subscribe to future articles by Michele Boldrin via this RSS feed.David K. Levine teaches economics at Washington University in Saint Louis and is co-author of Against Intellectual Monopoly. See his website. Send him mail. See his article archives. You can subscribe to future articles by David K. Levine via this RSS feed.Comment on the Mises blog.Notes[1] Lord [1923] p. 5–3.[2] Carnegie [1905] p. 157.[3] Much of the story of James Watt can be found in Carnegie [1905], Lord [1923], and Marsden [2004]. Information on the role of Boulton in Watt's enterprise is drawn from Mantoux [1905]. A lively description of the real Watt, as well of his legal wars against Hornblower — and many others — and of how he subsequently used his status to alter the public memory of the facts, can be found in Marsden [2004]. That Pickard's patent was unjust is also the view of Selgin and Turner (2006), who, like Watt, do not seem to provide any evidence of why it was so.As both the Lord and Carnegie works are out of copyright, both are available online at the very good Rochester site on the history of steam power. Later drafts of this chapter benefited enormously from the arrival of Google Book Search, which allowed us to check so many original historical sources about James Watt and the steam engine we would have never thought possible.[4] Lord [1923] gives figures on the number of steam engines produced by Boulton and Watt between 1775 and 1800, while the The Cambridge Economic History of Europe [1965] provides data on the spread of total horsepower between 1800 and 1815 and the spread of steam power more broadly. However, Kanefsky [1979] has largely discredited the Lord numbers, which is why we use figures on machines and horsepower from Kanefsky and Robey [1980].Our horsepower calculations are based on 510 steam engines generating about 5,000 horsepower in the United Kingdom in 1760. During the subsequent forty years we estimate that about 1,740 engines generating about 30,000 horsepower were added. This gives us our estimate that the total increased at a rate of roughly 750 horsepower each year. For 1815 we estimate about 100,000 horsepower — that is, the average of the figures Kanefsky and Robey [1980] give for 1800 and 1830. This together with the 35,000 horsepower we estimate for 1800 gives us our estimate that the total increased at a rate of roughly 4,000 horsepower each year after 1800.Data on the fuel efficiency, the "duty," of steam engines is from Nuvolari [2004b].[5] Kanefsky and Robey [1980] together with Smith [1977–78] provide a careful historical account of the detrimental impact of the Newcomen's, first, and of Watt's patents, later, on the rate of adoption of steam technology. Apart from the books just quoted, information about Hornblower's engine and its relation to Watt’s are widely available through easily accessible web sites, such as Encyclopedia Britannica, Wikipedia, and so on. Some details of Hornblower’s invention may be of interest. It was patented in 1781 and consisted of a steam engine with two cylinders, significantly more efficient than the Boulton and Watt design. Boulton and Watt challenged his invention — claiming infringement of their patent because the Hornblower engine used a separate condenser — and won. With the 1799 judicial decision against him, Hornblower had to pay Boulton and Watt a substantial amount of money for past royalties, while losing all opportunities to further develop the compound engine. His compound-steam-engine principle was not revived until 1804 by Arthur Woolf. It became one of the main ingredients in the efficiency explosion that followed the expiration of Boulton and Watt’s patent.Watt’s low-pressure engines were a dead end for further development; history shows that high-pressure, noncondensing engines were the way forward. Boulton and Watt's patent, covering all kinds of steam engines prevented anyone from working seriously on the high-pressure version until 1800. This included William Murdoch, an employee of Boulton and Watt, who had developed a version of the high-pressure engine in the early 1780s. He named it the "steam carriage" and was legally barred from developing it by Boulton and Watt's successful addition of the high-pressure engine to their patent, although Boulton and Watt never spent a cent to develop it. For the details of this story the reader should check the online Cotton Times or Carnegie [1905, pp. 140–141]. The "William Murdoch" entry in Wikipedia provides a good summary. More generally various researchers directly connect Murdoch to Trevithick, who is now considered the official "inventor" (in 1802) of the high-pressure engine. Quite plainly, the evidence suggests that Boulton and Watt's patent retarded the high-pressure steam engine, and hence economic development, for about 16 years.[6] The story about Pickard's patent blocking adoption by Watt is told in von Tunzelmann [1978].[7] Thompson [1847] p. 110 and quoted also in Lord [1923].[8] Scherer [1984] pp. 24–25.

I ran the preceding posts by a friend from law school who is now a partner in a patent law firm. His comments:

Hey Marc,

Interesting read, but the author is full of it. I notice hedoesn't address the most compelling case for patent protection -pharmaceuticals. Today, it costs $100 million or more to get FDAapproval of a new pharmaceutical (not to mention the research costs tofind the pharmaceuticals in the first place). After the innovator hasspent $100 million or more to adequately prove safetey and efficacy tothe FDA, a copyist can set up a rival manufacturing operation for a fewhundred thousand dollars and then piggyback for free on all thework/money the innovator has put in to proving safety and efficacy. Noone in their right mind would invest in a new pharmaceutical unlessthere was solid patent protection. Further, his example of the WrightBrothers is a poor one. Men had been trying to invent flying machinesfor hundreds of years before the Wright Brothers with a complete lack ofsuccess. The Wright Brothers needed to make a number of subtle, butcrucial, advances in wing shape and steering controls before they gottheir plane off the ground. These Wright Brothers inventions are stillfound in nearly all airplanes today. Are we really going to begrudgethe Wright Brothers 17 years of profits for making the entire aviationindustry possible ? Further, his point about the greatest advancesoccurring in the absence of patents is contradicted by his own examples.The Middle Ages is when we had an absence of patents and also an absenceof technology advancements. Today, we have an abundance of patents andan abundance of technology advances. Finally, the opening example ofremoving the Picasso from the wall says more about the uninformed, anallawyer providing that advice than the copyright laws. In my view,leaving the Picasso on the wall is plainly a "fair use" - I know of nocourt who would say that the Picasso must come down.

With that said, I don't dispute that there are lots of problemswith intellectual property today, including far too much of a "get richquick" mentality on questionable advances. In fact, I blame the "getrich quick" types, particularly in real estate and banking, for a largeportion our country's serious ills.